Are emerging markets becoming too efficient?

6th June 2013

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Could emerging markets have become too boring? Emerging markets have historically been seen as a natural stomping ground for active managers. Markets were inefficient, allowing for plenty of alpha generating opportunities. But with some estimates suggesting that as much as $2trillion is now invested in emerging market equities, is this opportunity diminishing? And if so, where else should investors be looking?.

Investment journalist Cherry Reynard surveys the expert opinion.

The large cap, high quality end of emerging market equities has had an extraordinary run of performance. This has been seen in the strong returns from the quality-focused emerging market funds from Aberdeen and First State. Multi-managers such as David Coombs, head of multi-asset at Rathbones, have suggested that the opportunities for outperformance in this part of the market are diminishing. Emerging market companies are increasingly well-covered by analysts as a greater number of investors move into the markets and corporate finance activity picks up. They have therefore, in many cases, become more ‘efficient’ in their performance.

Poised to benefit from this are the frontier markets managers, who can reasonably argue that their markets are truly inefficient because less capital has been directed towards them. Sam Vecht, manager of the BlackRock Frontiers investment trust, says: “Over the last decade or more, emerging markets have become much more efficient. The ability to add returns over and above the market are far less. Also, the markets have risen significantly, which has also diminished the likelihood of them rising further. There are now a lot of sensible intelligent people looking there.” He argues that frontier markets stack up better on yield, growth and volatility as he told Ft.com But money flowing into frontier markets has also increased, hitting $2.27bn for the year to the end of May. Citi analysts estimate that assets under management in frontier markets have reached $17bn, up from $12bn in the middle of last year. So this opportunity may also be diminishing, though no-one would argue that these markets are yet ‘efficient’.

Coombs has started to direct his cash towards the Asean markets. This has also been a popular choice with Jacob de Tusch Lec, manager of the Artemis Global Income fund, who believes the smaller Asian economies may be the key beneficiaries of the change in policy in Japan. He suggests that the flow of money relative to the size of these economies may even create bubble conditions in some areas.

But if analyst coverage is the problem, the answer may not be to focus on region, but to focus on size. Smaller companies globally have less analyst coverage, simply because they do fewer deals and are therefore of less interest to the corporate finance community. This is true whether they are in developed or emerging markets.

In this piece on Fundweb, Stephen Williams a divisional director at Brewin Dolphin, argues that the investment opportunity could be inversely related to the size of the company. The larger the company, the more coverage it attracts, and the more liquid are its shares with FTSE 100 index covered, on average, by 20 stock market analysts: “By contrast, the average small-to-mid-sized company is only covered by around five analysts. This offers greater opportunities to unearth value.”

However, the article also points out that the opportunity diminishes as companies are ‘discovered’. Mid-caps, for example, have had a strong run of performance and it is difficult to argue that they have been neglected by the investment community. Small caps are likely to command a greater ‘inefficiency premium’.

But before dismissing emerging markets completely, it is worth noting the views of Jason Pidcock, manager of the Newton Asian and Emerging Market Income funds. He believes that there has been a contraction of the opportunities in emerging markets as fund flows have been directed towards emerging markets, but they are still some way from being efficient: “These markets have a long way to go. Over the long term market forces should contract the opportunity, but it takes a long time. In Asia, for example, most countries outside Singapore are way behind Singapore. Even in Australia, we believe we can make a difference.”

Others, such as Ken French of Dartmouth College and a director of Dimensional Fund Advisors, Wall Street Journal blogsite reject the notion of inefficiency altogether: “Considering how cheap it has become to trade stocks, the hundreds of millions of investors competing over them every day and the massive amounts of research generated around the world, it isn’t very likely that screaming bargains will go unheard or that absurd overvaluations will persist for long. Also, when shares are thinly traded, they are more expensive to buy and sell. So any mispricing has to be substantial before anyone will step in and trade on it.”

More worryingly, French adds: “Consistently, the funds pursuing opportunities in “inefficient” markets like small stocks, real estate or emerging markets don’t look any better than those investing in the biggest U.S. stocks.” It should be said that French was writing before the start of the significant bull run in equities seen over the last eighteen months, and Dimensional is a provider of funds with a more passive approach, however, it does suggest that investors should be wary about swallowing the line that inefficient markets are good for active managers wholesale.

The most logical conclusion, perhaps, for investors, should be that markets do not remain efficient and that inefficiency may not be all it’s cracked up to be anyway. Arbitrage opportunities can exist, but they are diminishing in emerging markets as there are more investors researching and trading those companies.

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