BOSTON, January 6 – 2004 was the fourth consecutive year in which emerging markets outperformed developed markets and the fifth time they have done so in the last six years. The 22.4% return of the benchmark MSCI Emerging Markets Index exceeded the 17.6% gain by the EAFE Index and the 12.8% rise in the World Index. Funds with exposure to emerging markets shuffled their country allocations to navigate the wide range of performances in the asset class, from the 59-88% returns of Central European markets and Indonesia’s Asia-leading 45% gain this year to the 4% decline of Thailand’s MSCI country index.
The 139 diversified Gobal Emerging Market (GEM) equity funds tracked by Emerging Portfolio Fund Research (EPFR) had returned 16.5% year to date to the beginning of December [end of year performance data will be released in mid-January], which was in line with the benchmark index. However, the best performing funds were trouncing the benchmark with returns close to 30% by making good country allocation decisions.
Country Bets that Paid Off
“It is worth following the country allocation decisions of GEM equity funds if you want to do well in emerging markets,” said Brad Durham, a managing director of EPFR. “The GEM funds we track have beaten the index in seven of the last eight years by a cumulative return of 27%. And if you built a portfolio comprised of country index funds that mirror the average country allocations of these GEM funds, rebalancing monthly, you would have beaten the benchmark by 22% alone in 2003 and by 11% per year going back to 1995 for an annual return of 13.5%. That’s why we call these funds ‘the smart money.’”
As a result, the country bets of top performing funds can be a signal for future market performance. As of December 1 the JP Morgan Fleming Emerging Markets Equity Fund Institutional fund had returned 29.3% and was sitting on substantial overweights to India and Brazil, two of the best performing emerging markets in the fourth quarter of 2004. The fund had a collective weighting of 20.9% in those two markets against a combined benchmark weighting of 14.8%. But also helping performance was its major underweight of Taiwan and its zero weighting to Thailand, both of which have been poorly performing markets this year. The Acadian Emerging Markets Portfolio, managed by Boston-based Acadian Asset Management, has returned 29% due in part to its big overweights of Indonesia and Turkey and its zero weighting to Thailand. Notably, the fund is virtually out of Mexican equities, with a paltry 1.1% allocation compared to the benchmark’s 6.2% weighting, and is loaded up on Russian holdings, maintaining a 10% weighting versus the benchmark’s 3.5% weighting to Russia. Meanwhile, the London-based Genesis Emerging Markets Fund has earned its excellent performance this year by making intrepid bets on India and Egypt while holding only trace amounts of Taiwan equities.
Heading into 2005 the country weightings of GEM equity funds look considerably different than they did entering 2004. While funds added slightly to Korea as their leading country allocation despite the market’s tepid performance this year, South Africa has leap-frogged Brazil and Taiwan to become the second favorite market of GEM fund managers with a weighting of 11.5%, up from 9.5% at the start of the year. Meanwhile, funds significantly reduced their exposure to India and Thailand while adding to Indonesia and Egypt. While funds were aggressively buying Taiwan equities for much of this year, their weightings there hardly budged due to Taiwan’s poor performance relative to other emerging markets.
GEM funds are also entering 2005 with a collective weighting of 51.4% to Asian equities, their smallest exposure to the region since June 2003. This weighting is down from a 55% allocation in May 2004, when Asian markets tumbled on ramped-up expectations of a speedy return by the Fed to raising interest rates. Weightings in Africa/Middle East equities rose in 2004 from 11.7% to 14.2% while their allocations to Latin America and Emerging Europe remained about the same.
GEM fund managers are generally optimistic about the fortunes for emerging markets in 2005, based on the low relative valuations of the emerging markets universe that is trading at a multiple of about 14x forward earnings (compared with 20x for the S&P 500), the improving fiscal position of many emerging markets, and strong economic growth that is increasingly driven by rising domestic demand throughout the asset class.
Country Flows
While the country and regional exposure of funds heading into the New Year is instructive, so is the recent net buying and selling, by country, of all types of funds with emerging markets holdings. A range of funds with emerging markets holdings report their country allocations on a monthly basis to EPFR. These funds include Global/International, Global Emerging Markets (GEM), Asia ex-Japan, Latin America, EMEA and Pacific equity funds with $260 billion in total assets and are registered in various global fund domiciles, including the US, Luxembourg, Ireland, Caymans, etc.
In 2004, these equity funds bought more than $2.1 billion worth of Asian equities and their three favorite markets in the EM universe were all in Asia: Taiwan, Malaysia and India. Funds tracked by EPFR were also net buyers of $1.3 billion of EMEA (emerging Europe, Middle East, Africa) equities, with their favorite markets in these regions being Russia, South Africa and Israel. These funds, however, did not ratify the mainly domestically driven rally in Latin American that propelled the region’s benchmark index to a gain of 34.7%. They were net sellers of $2.8 billion of Latin America equities as all types of funds offloaded their Mexican equity holdings: GEM equity funds, for example, have reduced their Mexico allocation to an all-time low of 6.4%.
The emerging market country receiving the most attention in 2004 was Taiwan, which received net buying from equity funds of $1.7 billion in 2004. In November, Taiwan equities experienced the heaviest buying from equity fund managers since March 2000 as funds were net purchasers of more than $800 million. Funds were aggressively buying Taiwan in the first half of the year and at year’s end in advance of an expected upward re-weighting of Taiwan in the MSCI EMF index due to the Taiwan government’s decision in 2003 to eliminate restrictions on foreign institutional investors. The first of two parts to Taiwan’s re-weighting in MSCI indices took place at the beginning of December. Also notable in recent months was a sudden shift towards buying Israeli equities on a new optimism following the death of Yasser Arafat, a shift to buying of Brazilian equities and six straight months of selling Russian equities on investor uncertainty resulting from the campaign waged by the government against Yukos. Funds are also buying South African equities again and GEM equity funds have taken their allocations to that market to an all-time high.
Many funds were forced to sell Latin American equities, even though they generally believe in the region’s continuation of economic growth in 2005. With the benchmark EM Latin America index returning 34.7% in 2004, funds were found resisting a sharp increase to their overweight in LatAm equities and, thus, were forced to sell as regional equities rose. GEM equity funds in December had a 19.7% allocation to the region, compared to the benchmark’s 18.8% weighting.
Regional/Country Updates
Asia: funds finding dollar cuts both ways
Fund managers have been scrambling to allocate the recent healthy inflows into emerging market equity funds where many of the blue chip plays are exporters that suffer when the dollar is weak. As a result, GEM funds have been steering money into the Asian markets that have the best domestic demand stories or, in the case of Thailand, seem particularly undervalued. These strategies converged in Taiwan, where consumers are borrowing and spending – especially on property – and valuations in the key technology sector appear to have bottomed out.
China: Chinese equity markets have slipped as fund managers sought to make sense of the central bank’s first interest rate hike in nine years. EPFR-tracked funds largely interpreted it, and the scrapping of the ceiling on commercial lending rates, as another small step towards the rational, market-based allocation of capital. Equity funds have been net buyers of Chinese equities for six straight months and bought a net $305 million of mainland Chinese equities in 2004, the 7th most bought emerging market. And since some fund managers consider Taiwan a play on China, some of Taiwan’s country flows may be attributed to China’s allure.
India: India has seen net selling by equity funds for two consecutive months as fund managers shuffled their portfolios in light of 3Q04 earnings, rising interest rates and high energy prices. The bottom-up story remains good for blue chip Indian companies. But questions remain about the economic policy environment, this year’s monsoon, inflationary trends and the impact of higher labor, energy and capital costs on profit margins. Equity funds tracked by EPFR, however have been net buyers of $768 million of Indian equities this year, the third most bought market by foreign funds. Funds lined up to become net buyers of $282 million of Indian equities in November alone. GEM equity funds, however, have trimmed their India weighting from an all-time high of 7.5% in January 2004 to 6.2% at year’s end.
Indonesia: EPFR-tracked funds were net sellers of $664 million worth of Indonesian equities in 2004 despite GEM and Asia ex-Japan equity funds increasing their weightings to this market. Funds sold into end-of-year strength since the domestic market has performed well as investors have been buying into the reform story promised by the election of Susilo Bambang Yudhoyono, who was inaugurated as president in late October. The benchmark Jakarta Composite index posted a series of year-to-date highs on the back of demand for reasonably priced resource stocks.
Korea: An indifferent 3Q04 earnings season, the impact of a stronger won on Korean exporters and cooling sentiment towards technology stocks all played a role in convincing fund managers to book profits in the last couple of months after a four-month run of net buying of Korean equities in the fall. Hopes for the domestic economy also took a hit when the a $40 billion government plan to shift Korea’s capital city was blocked by the courts. GEM and Asia ex-Japan equity funds exit 2004 with about the same allocations to Korea as they entered.
Malaysia: A ratings upgrade, allied to the government’s long-term commitment to reducing corruption and reforming state-linked companies, has kept a floor under this market and inspired about $921 million of net buying in 2004. But the 3Q04 corporate earnings season seemed to confirm the view that Malaysia currently offers investors modest growth at a rich price unless they are willing to prospect among the riskier second and third tier stocks.
Philippines: Funds have been net buyers for four consecutive months, which has helped the Philippine equity market to rally. But consumers, facing tax increases while dealing with inflation running north of 6%, are losing patience with the government. Ratings agencies are also on edge as tax bills aimed at closing the country’s fiscal gap make slow and uncertain progress through the legislature.
Taiwan: Attractive valuations and positioning ahead of the index re-weighting by MSCI pulled plenty of foreign money into Taiwanese equity in recent months, culminating in November’s $813 million deluge. However, poor sentiment in the technology sector remains and Taiwanese equities are still struggling to distance themselves from the year-to-date lows posted in August. Fund managers in recent months have gone looking for stocks geared to Taiwan’s strong domestic demand story or to the consolidation theme in the financial sector. Oversold technology stocks also attracted some attention.
Thailand: Fresh unrest in the south pulled the rug out from under a Thai equity market that started the fourth quarter at a gallop thanks to good 3Q04 earnings season and a well received IPO. EPFR-funds have been net sellers of Thai equities in eight of the last nine months. Valuations remain compelling: the P/E of companies listed in Thailand’s benchmark index is only about 8x. But the potential for the unrest in southern provinces to grow, allied to doubts about the government’s ability to handle an escalation, kept investors and fund managers on the sidelines. Through the course of 2004 GEM equity funds have reduced their weightings from 4.6% to 3.3% while Asia ex-Japan equity funds have cut their exposure from 7% to 5.2%.
Latin America: Foreign funds sell on strength
Boosted by strong global demand for energy, minerals and agricultural commodities, bourses throughout the region gained ground in 2004, with some markets posting all-time highs. But it has been domestic investors that have pushed equity markets higher as foreign fund managers sold into strength in 2004, offloading $2.84 billion of regional equities than they bought during the year.
Argentina: Argentine equities are faring well as the economy regains momentum and efforts to resolve the country’s massive default take another step forward. The benchmark Merval index has set a series of year-to-date highs. Argentina’s government pushed for an extension of emergency economic powers that allow it to cap utility rates and limit layoffs.
Brazil: The export-led recovery in Brazil continues to gain traction, with GDP on track for solid growth in 2004 and continuing into 2005. Valuations remain attractive: companies listed in Brazil’s benchmark equities index are trading at a P/E of 11.7, compared to 15.4 for Mexico and 19 for Chile. Equity funds took profits in 2004 and were net sellers of about $971 million worth of Brazilian equities.
Chile: A rally by Chile’s equity market has fresh pressure of valuations and fund weightings. EPFR-tracked have been net sellers of Chilean stocks for six straight months despite rising commodity prices. Chile continues to offer investors steady growth, but high energy costs, stubborn unemployment and the increasingly populist tone of the government is curbing the appetite of fund managers for this expensive market.
Colombia: Reform, strong demand for natural resources and an improving security situation has made Colombia the world’s best performing equity market. Equity funds tracked by EPFR have added to their modest bets on this market for two straight months. Fund managers are watching the progress of legislation to curb public pension costs as they try to gauge the prospects for further economic reform.
Mexico: EPFR-tracked funds have been net sellers of Mexican equities for nine of the last 10 months and a stunning 20 of the last 23 months, during which time they have been sellers of $2.8 billion of Mexican stocks. GEM equity funds now have an average Mexico weighting of 6.4%, the smallest allocation to this market since EPFR began tracking country weightings in 1995. Inflationary fears, political inertia and rich valuations have taken their toll on sentiment towards Mexico despite the solid performance of its benchmark MSCI index, which is set to return more than 40% in 2004.
Peru: Mineral-rich Peru ended an 11-month streak of net outflows in October and November as the US dollar’s weakness put a fresh shine on its gold exports. Sentiment towards this market was also helped by the unusual resolution Peruvian legislators are showing in their efforts to overhaul the public pension system. But fund managers remain wary. The government remains deeply unpopular and consumer confidence low. Furthermore, there are a limited number of quality companies in play, and for the most part they are fully valued.
Venezuela: Loose lips sink equity markets as well as ships, and populist Venezuelan President Hugo Chavez’s remarks about confiscating property and intervening in the telecommunications sector sent more money to the sidelines in October. EPFR-tracked funds have been net sellers for four straight months. The inability of the opposition to mount an effective challenge is forcing fund managers to pay more attention to the sweeping, redistributive economic agenda articulated by Chavez. High oil prices have, however, kept a floor under this market.
EMEA: demand for non-Russian regional assets holding up
With the weak US dollar and slowing Eurozone growth putting pressure on the export story, emerging market equity fund managers are gravitating towards markets with strong domestic demand such as Hungary, South Africa and Turkey. Expectations of more broadly based growth have also helped Poland and Israel.
Czech Republic: The Czech equity market has managed to return more than 67% this year. But with valuations high and 3Q04 corporate earnings meeting rather than exceeding expectations, EPFR-tracked funds have been only tentatively buying this market. The Czech central bank, faced with low inflation and the fact the terms of four board members expire in February, 2005 has little incentive to antagonize the government by further monetary tightening. That suggests the current brisk GDP growth will continue into 2005.
Egypt: The promise of reform helped Egypt’s equity markets extend their 3Q04 rally, climbing 18% in the quarter and 111% on the year. Pressure on fund weightings that are well north of the MSCI benchmark have caused EPFR-tracked funds to be net sellers of Egyptian equities in recent months. Domestic investors are encouraged by the efforts of a reshuffled cabinet to jump-start the privatization process and cut the tax burden on both individuals and corporations.
Hungary: Growth prospects and its equity markets got a boost in the fourth quarter when the central bank cut its base interest rate by 50 basis points. Investors responded by pushing the MSCI Hungary index up by more than 30% during the quarter. EPFR-tracked equity funds have mainly been along for the ride as net buyers for three straight months. Lower interest rates make life easier for Hungarian exporters who have suffered because of domestic currency strength. The country’s fiscal position, however, continues to deteriorate.
Israel: EPFR-tracked funds have been net buyers of Israeli equities for three consecutive months as the country’s export-led economic recovery continued to broaden. With domestically oriented plays offering growth at a reasonable price, Global/International equity increased their holdings in this market by an eye-popping 55% in October despite the drag exerted by the technology sector. Sentiment towards this market was also helped, for a change, by political events: legislative approval of a controversial plan to pull out of Gaza, and Yasser Arafat’s final illness, raised hopes of a long-term improvement in Israel’s security situation.
Poland: The combination of robust growth, improving public finances and benign inflation has helped Poland attract net buying from funds for three straight months. Poland’s recovery continues to be externally driven, with exports up, as higher taxes and a soft labor market weigh on domestic consumption. But fund managers expect a more accommodating monetary and fiscal environment in 1H05. The central bank is signaling that its recent tightening cycle is over, while legislators are beginning to focus on next year’s parliamentary elections.
Russia: A new round of arbitrary tax demands aimed at the energy sector in general and oil major Yukos in particular led to a declining Russian equity market in the fourth quarter. This prompted EPFR-tracked funds, however, to take advantage of the bargains and buy Russian equities towards year’s end. Russia continues to benefit from high oil prices and the government’s fiscal discipline.
South Africa: Funds are buying South African equities again as faster than expected economic growth in 2004 is resulting in upward revisions to growth forecasts in 2005. Rising commodity prices and the strength of the rand has also attracted attention. GEM equity funds now have an 11.5% weighting in South Africa, their highest weighting since EPFR began tracking this data in 1995.
Turkey: Expectations that Turkey would be invited to European Union accession talks helped that market to a 22% gain in the fourth quarter and equity funds have been net buyers of Turkish equities for two straight months. In addition to the convergence theme, Turkey continues to offer strong fundamentals and falling interest rates. GDP growth is on track to hit 8% this year on the back of stronger than expected private investment and consumption.
About EmergingPortfolio.com Fund Research
Cambridge, Massachusetts-based EmergingPortfolio.com Fund Research tracks equity and bond fund flows, cross border capital flows, country and sector allocations, and company holdings data from its universe of 7,000 international and emerging market funds with more than $3 trillion in assets. EPFR data comes directly from funds or their administrators and includes funds registered in the major domiciles of North America, Europe, Asia and other offshore domiciles. The data shows trends in global institutional and individual investor sentiment and is used by top emerging markets and international analysts, strategists and portfolio managers. The firm also provides investment management clients with qualitative analysis on international markets and operates EmergingPortfolio.com, an Internet site for institutional investors in emerging markets and listed in Forbes Best of the Web.