A higher-for-longer interest rate environment has been priced into emerging market (EM) stocks. As a result, we have been witnessing a textbook script on stock performance in a rising rate environment: EM risk assets have underperformed, EM currencies have sold off, earnings expectations have come down, and interest expense has been rising, with value/quality equities outperforming. However, this should be expected and the fact that we have (mostly) crossed the river without significant stress indicates that we may be getting closer to an entry point. Other asset classes (such as US equities) have defied gravity for too long and relative positioning (developed markets versus emerging markets) has become fairly extreme.
Our review of emerging market equities begins with a single word: skew. Skew refers to the measure of asymmetry in the distribution of market returns. In a ‘normal distribution,’ skew is zero. What a nice and neat world it would be if market returns exhibited normal distributions! While we recognize that ‘normal’ doesn’t often exist in the “real” world, it most certainly does not happen in emerging market equities. As investors, we are thankful that this is the case for this dynamic drives active alpha generation. A return distribution that shows ‘fat tails’ is a blessing for it increases the opportunity set for investment managers to add value. However, negative skew (more common jargon), or where outliers on the downside outweigh the upside, is not a blessing. While a large right tail of the distribution suggests that managers who have real skill can generate meaningful excess returns in emerging markets, one must be careful. (Figure 1).
Figure 1: Downside vs. Upside Risk in Emerging Markets
The graph above shows the annualized 5-year returns of all the stocks in the MSCI Emerging Market index. The index exhibits significant “down-side skew” — that is, the winners are outweighed by the losers by approximately 2.5–1 (in the second chart above one can see this skew is even worse in emerging market small caps). Again, for skilled investment managers, there are plenty of stocks that can generate strong alpha (more so that one could find in developed markets). However, like in most avenues of life, there are no freebies. The cost here is that if one takes concentrated positions and does not bring skill (or more charitably, gets unlucky), the impact of falling into the left side of the distribution can be quite painful (when one has high single-stocks portfolio positions). If we recall our algebra, if one has a 50% draw down in a specific position, one will need to a 100% gain to get back to where you were. Math is just so unfair like that. And the portfolio implication will be felt — at best — by total portfolio volatility and at even worse, by index underperformance — and quite likely both.
Harry Markowitz was reported to have said that “Diversification is the only free lunch in finance.” This is true in most cases, yet when dealing with downside risks, it really is the best way to preserve your capital. It is almost inevitable that any active manager can make a mistake, whether he or she follows a fundamental or quantitative approach. However, quantitative managers generally understand this is their portfolio construction and often will hold several hundred positions. They know that their signals are less powerful at the single security level, but robust at the portfolio level. Therefore, quantitative managers prefer to limit the amount of idiosyncratic risks. We prefer to keep our risk diversified to the broad underlying themes — whether it be value, quality, or the like — that generate portfolio alpha. We focus more on the broad forest, less on the single tree.
Figure 2: Bad Luck or Bad Skill?
If a manager is running a portfolio at a tracking error of 3%, for example, we can run a scenario to see how many “bad stocks” it will take to reach their tracking error limit. The concentrated manager, holding 40 names, can reach this limit with three poorly performing stocks — assuming all else is constant. One can imagine the concentrated manager hitting this limit with some degree of frequency when there is a whiff of sector volatility or simply bad news. For the diversified manager, that number rises to 37 — making it less a case of pure idiosyncratic risk versus style/factor positioning. The question of bad luck versus bad skill does begin to blend, but if a manager has a 3% excess return target, wouldn’t one simply prefer to take that with greater diversification? This should provide a better information ratio. In this, the math is really fair.
The stylized example above is useful, to a point. The next question one should ask is how this affects managers more broadly. We can think about this as such: firstly, what is the relationship between active share and portfolio (relative) drawdowns. Intuitively, one might think there is a linear relationship here, but as Figure 3 shows, this is not the case. The last five years have been ‘peculiar’ with pandemic, war, and rising geopolitical tensions. However, it is likely we will continue to see heightened risk in the years ahead. In short, this active share/ drawdown relationship could remain unpredictable.
Figure 3: Max Drawdown over 5-Year Period
The wise words from a long-ago mentor ring as true as ever in today’s markets: “Concentrated portfolios work — until they don’t” And for emerging markets, it is not enough simply to be diversified. Identifying names to avoid is as critically important as selecting names to hold in a portfolio. In the long run, one often wins by not losing.
As we begin to look out to 2024, we see a relative value play in EM returning with higher rates. We think shorter duration assets are the best play, ideally ones without a strong cyclical exposure. Controversially, we are starting to add positions in China — but selectively. Our strategy is to avoid crowded trades, be careful on the quality dynamics, and do not try to catch any falling knives. The information technology (IT) and energy sectors in China look attractive at current valuations in the large cap space. The 2024 outlook for IT in Taiwan looks stellar across the capitalization spectrum, as do the consumer names in Korea. As always, stay diversified and keep looking for balance in your positions.
Figure 4: Current Positioning