Many years ago when my family and I took a trip to London my children took great delight in hearing the loud warning of “mind the gap” when taking the Tube.
To this day we still joke about it and hearing the expression always brings back a flash of fond memories.
But what I had in mind for this note was a different type of gap. Specifically, the gap that is developing between developed equity markets and emerging market stocks.
Going into 2016 sentiment was pretty bearish on emerging market equities. Institutional investors were having a hard time hanging on to allocations that significantly under-performed expectations and retail investors had long been fleeing the asset class.
Moreover, over the prior ten years (2015-2006) emerging markets had only out-performed international developed markets by an annualized 0.45%. Clearly not enough once transaction costs and the usually higher management fees are taken into account. Never mind the higher volatility of the asset class.
So what had happened to the emerging markets story? Investors once justifying their EM allocations on the growth of the middle class in these markets (the shift from export-driven to domestic consumption growth) had reverted back to explaining the disappointing performance of EM equities as a function of the collapse in global commodity prices.
At the end of 2015 it was hard to find investors willingly delinking expectations for EM equities from those of global commodity markets. Both asset classes ranked at or near the bottom of the pile in terms of 2016 prospects.
Not that every investors was bearish but you had to be a true contrarian to in the face of public ridicule increase allocations to EM or commodities. The short EM/Commodity trade had become very crowded indeed!
What usually happens when you have a crowded trade? The short answer is nothing good for the crowd except for the small number of contrarians still hanging on. Let’s think back to two recent examples of crowded trades:
The rise and subsequent bursting of the TMT bubble of the late 90’s. Every portfolio manager back in those days felt the pressure to increase their exposure to companies in these sectors despite a lack of sound fundamentals and exorbitant valuations.
- The real estate finance smorgasbord of builders, mortgage issuers, insurers and credit re-packagers of the 2004-2007 period. The finance sector as a whole was gorging on low interest rates in the context of a low volatility capital market environment. The end result was not unpredictable but in its day there was comfort in numbers and the possibility of something seriously going wrong was summarily dismissed by the vast horde of investors then making money on the trade.
- The funny thing about crowded trades is that before they burst few people are willing to take a count of the players at the party. Sometimes people will fail to even acknowledge that a party is taking place. Tunnel vision sets in and investors are subsequently surprised when a turn of events has party attendees suddenly sprinting for the exits.
Is the short EM equities trade finally nearing exhaustion? It sure feels like it. Systematic ways of looking at the “numbers” will invariably lag price behavior. Our own allocation models have been pointing to a closing of the gap between expectations for developed and emerging market forward returns but we still slightly prefer the former.
Let’s take a look at major asset class performance in 2016.
- Last week EM equities were up 3.3% – best of the major asset class categories.
- For the year, EM equities are up 4.4% -best among all equity sub-asset classes.
- The gap between emerging and developed international market (EAFE) performance is widening. Year to date the gap stands at over 7%.
- The MSCI EAFE index is down 2.68% for the year while the MSCI ACWI-x US index (which has an EM weight close to 20%) is down approximately 0.4%.
The performance gap between developed international and emerging market equities is already causing some anxiety among international equity managers. Managers tied to the broader ACWI index are clearly having to swim upstream given their likely beginning of year under-weight to EM stocks.
Last year the consensus underweight to EM equities paid off handsomely. EAFE out-performed EM equities by a whopping 14%. An under-weight to EM equities could have hidden a lot of sins elsewhere in the portfolio but this year the tide has turned.
Having been a money manager for over 20 years I know the feeling when a previously ignored/disliked segment of the markets suddenly changes course and gaps up.
It’s never a good feeling and leaves portfolio managers in search of answers. In the course of my career I have seen three types of generic responses by managers:
- Ignoring the problem and remaining steadfast in the belief that the portfolio is correctly positioned. The likely outcome of the “no action” manager is binary – at the end of the year the manager will either be a hero or a goat.
- Gradually changing course acknowledging that the trade might have been crowded. The manager works at finding investments with the right exposures thus gradually minimizing the under-weight to the previously ignored/disliked segment. In all likelihood the manager will initially make small adjustments and is praying that the performance gap does not widen too rapidly
- Throwing in the towel and joining the new party by aggressively over-weighting the previously maligned investment. The potential to be a hero or a goat is large. Such a response is usually driven by “gut” feelings that things have changed
Only in hindsight will investors be able to tell which course of action resulted in the best outcome. Portfolio managers live in the present and must make decisions. With that in mind here is set of principles to adhere to:
- All predictions contain a certain amount of error – be humble about your ability to predict the future. Low probability events happen more frequently than we would like to
- Seek to understand opposing points of view as a way to discover flows in your thinking. You will gain a greater appreciation of what can go wrong
- Strike a balance between what is happening now (recent evidence) and longer-term information. Don’t let your decisions succumb to feelings of either fear or greed
- Research-based views are better than reactive off-the cuff conclusions – at least you will understand why you made certain decisions. Do your homework
- Gradually changing one’s views given changing/new information is not a sign of weakness. Making better decisions involves the constant calibration of new probabilities
- There is no substitute for experience in providing context to the decision at hand, but experience without analysis is no way to make decisions in an ever evolving capital market environment
- Understand the consequence of your decisions – never bet the farm on one major decision unless you (and your clients) are comfortable with binary outcomes
Eric J. Weigel
Managing Partner of Global Focus Capital LLC