EM, Just Beat it! (Don’t Hug the Index)

 

Since the 2008 financial crisis, investors have flocked to emerging markets (EM) for return generation as developed markets (DM) have faced low interest rates and slowing growth. A common institutional investor approach to EM is to combine a long-only allocation with a long/short, hedged allocation. Much has been written about hedged investing, but less about approaches to implementing the long-only EM allocation. This viewpoint addresses commoninstitutional approaches to long-only EM allocations.

There are two routes institutional investors can pursue to implement their long-only EM allocations: (1) passive allocations through index funds and ETFs; and (2) active allocations through mutual funds, and increasingly, long-only hedge funds (i.e., long-only absolute return funds). ‘Long-only hedge funds’ may seem like a misnomer since these vehicles do not short. However, these vehicles fall into the hedge fund category because they are typically run by hedge fund managers with similar long/short vehicles. Generally, these managers remain focused on absolute return generation, and their portfolio construction is usually agnostic to a benchmark. Long-only hedge funds have become the EM equity ‘flavor of the month,’ as index-beholden investment vehicles offer a poor risk/return profile and miss many of the opportunities for alpha available in EM through active management.

EM Country Indices Provide Limited Exposure to Growth Drivers

Although passive investment options in EM through index funds or ETFs provide a relatively cheap and efficient way to gain exposure to EM beta, they may be too blunt of an instrument to effectively achieve an investor’s risk and return goals. Passive investing is problematic because most EM country indices have small market caps and are dominated by either a particular industry, like natural resources or financials, or are heavily weighted towards state-owned or influenced companies. Some EM indices incur both biases. These attributes of EM indices pose two problems for an investor. First, through the index fund or ETF, an investor receives an allocation to an industry that may not be the primary growth driver of the country. For example, China’s H-Shares are biased towards financials and exporters while the country is publicly and aggressively seeking to stimulate domestic consumption. Second, through the index fund or ETF, an investor may be allocating to a company that is managed according to government policy rather than objectives to maximize shareholder value. Brazil’s Bovespa index, for example, has a roughly 9% weight to Petrobras, a company managed as part of the governing political party’s platform to contain inflation. Passive investments through index funds and ETFs mimic EM indices and thus are prone to these inherent biases. While passive investments are cheap, they may be poor investment vehicles to capture the robust and diverse growth drivers of an EM economy.

EM Long-Only Hedge Funds Can Be More Effective Because They Are Not Beholden to the Index

Long-only hedge funds have become increasingly attractive because of the freedom to deviate from a benchmark and size positions in a portfolio without regard to the broader index. Although mutual funds are actively managed, they are benchmarked closely to the relevant broad EM or country index. This limitation may create a risky proposition for mutual fund managers who wish to take positions outside of the index. Evidence of the index-like returns of mutual funds is seen in the table below, with mutual funds exhibiting a beta of 1 to the MSCI Emerging Markets index.1 In addition, the index-like behavior of mutual funds comes at hefty price tag­ — a 1.2% average fee for institutional class emerging market equity mutual funds based on Morningstar data. This fee is more than the roughly 1% flat fee typically charged by long-only funds run by hedge funds.2 Long-only hedge funds have become attractive to investors for another reason as well. Although these funds do not short equities, the ability to completely avoid particular names can be a meaningful source of alpha versus a comparable index. Long-only hedge funds (as proxied by the Eurekahedge Emerging Markets Absolute Return Fund Index) exhibit a lower beta to EM indices and better risk-adjusted returns while still maintaining a long-only positioning (see table below).3The improvement in the risk/return profile of long-only hedge funds becomes especially important in EM which is subject to large drawdowns and volatility.

  Annualized Return Annual Volatility Beta to MSCI EM Index
Average Mutual Funds* 10% 23% 1.0
iShares MSCI Emerging Markets ETF (EEM) 12% 24% 1.0
Eurekahedge Emerging Markets Absolute Return Fund Index 13% 17% 0.7
Credit Suisse Emerging Market Hedge Fund Index 9% 10% 0.4
MSCI Emerging Markets Index 12% 23% 1.0

*An average of 183 Emerging Markets Equity Mutual Funds screened from Bloomberg. All data from May 2003, the inception of the EEM index. There is a survivorship bias in the average mutual fund data since these are returns only from funds that are in existence today with track records dating back to May 2003. There is a backfill bias in the Eurekahedge Index.

Although long-only hedge funds appear to be a superior alternative for implementing a long-only EM allocation, institutional investors will face challenges. Assembling a portfolio of long-only hedge funds can be difficult due to the small universe of available funds, limited capacity, and limited track records. Although a recent Deutsche Bank survey indicates that institutional investor demand for long-only products is large, with more than 40% allocating to hedge fund run long-only vehicles, the biggest hurdle has been selecting managers from the limited supply.4 The long-only EM equity hedge fund universe is relatively small at only about $12 billion in total assets, according to recent Morningstar data. This compares to $125 billion of assets in institutional class EM equity mutual funds, of which more than 10% is closed to new investment. In addition, the long-only EM equity hedge fund universe is also skewed towards more recent fund launches, making returns based analysis woefully inadequate based on short to non-existent track records. Given the need to creatively address capacity issues and work with hedge fund managers to build and customize a long-only investment vehicle, a fund of hedge funds may provide valuable expertise to resource-constrained institutional investors. Challenges aside, institutional investors will likely continue to prefer long-only hedge funds for desired EM exposure. EM long-only hedge funds offer an investment opportunity that can overcome the aforementioned inefficient biases in EM indices, while also introducing new sources of alpha through domestic, idiosyncratic opportunities.

1Comparisons to indices have limitations because indices have volatility and other material characteristics that may differ from a particular fund. Broad-based indices are unmanaged and are not subject to fees and expenses typically associated with a fund or managed account. One cannot invest directly in an index. A hedge fund’s performance may differ substantially from the performance of an index. Because of these differences, the indices shown are not benchmarks, should not be relied upon as an accurate measure of comparison, and are shown only to present a comparison among asset classes. Unless noted otherwise, all index returns are denominated in U.S. dollars.

2 Hedge fund run long-only fees vary substantially and there is very little data available on the asset class. Our experience has ranged from funds offering much lower management fees, in the range of 40-50 bps with a higher performance fee to a hedge fund like fee structure of 1% management fee, 10% performance fee. A 1% flat management fee is middle of the road for what we have seen.

3  See footnote 1.

4 “From alternatives to mainstream: Hedge funds’ changing role in the asset management industry.” Deutsche Bank Survey (November 2013).​

Alexandra Coupe, CFA, CAIA, CQF is an Associate Director working in Portfolio Management focused on capital markets. She is a member of the firm’s Strategy Allocation Committee where she focuses on assessing the impact of asset and strategy allocation on overall portfolio risk and performance. Her experience also includes research, due diligence and risk monitoring across all PAAMCO strategies with an emphasis on credit strategies and emerging markets. Prior to joining PAAMCO, Alexandra was a Research Associate at Green Street Advisors, a boutique REIT research company where she focused on European and U.S. REIT equities. Alexandra began her career as an investment analyst at PAAMCO where she focused on merger arbitrage and constructing custom client portfolios with an emphasis on Asian institutions. She has eight years of investment management experience focused on alternative assets. Alexandra graduated from the University of Virginia with a BA in Economics and received her MBA from the Wharton School of Business at University of Pennsylvania.

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