Mark Potter

Pottering About

As we come to the end of the first 3 months of the year, it makes sense to take time to pick out what has turned out to be different or at least moved on, much as the weather does.  There have certainly been some notable changes in the investment market background, perhaps not surprising after a change of government (and huge sigh of relief) in the USA, the real Brexit event and a varied start to the Covid-19 vaccination programmes globally.

This month, I offer for your contemplation a selection of topics where I think recent developments are worth noting and perhaps reacting to in your portfolio construction and review.

What’s new?

These are facts that I would propose are relevant to investors and should be allowed for in portfolio reviews and shorter-term tactical purchase and sales of funds or ETFs:

Sterling on the up

Sterling has appreciated significantly against all other major currencies.  I have already commented on possible reasons for that in my weekly posts.  This will have cut back returns on overseas investments and gold and on its own generated short term portfolio value reductions. 

The tough questions is whether or not this is a permanent reset – my opinion is that for the time being it is and what is more, there is likely more Sterling appreciation to come.  A response to that would be to increase ‘home’ weightings in portfolios.

Value makes a comeback

An inflection in the relative performance of value shares has, as I predicted, already happened.  The MSCI World Value Index underperformed the main MSCI World index by 17% in 2020, but was up about 4% in the first 2 months of 2021 when the main index was up less than 2% (source: MSCI).  Value funds with a bias to small and mid-cap companies have produced outstanding returns over the last 6 months with some UK funds showing returns in excess of 40%. 

I don’t believe that is the end of the potential comeback as many assets in this segment are still trading at below long-term trend prices whereas the assets driven by momentum over so many years are still looking very pricey.

SPACS will buy any old company and are coming to the UK – maybe!

It is reported in US news media that regulators are becoming seriously concerned about unsophisticated investors putting their trust in SPACs that they don’t understand just because they are launched with a stuck-on celebrity name label.

As has been the case so often in my lifetime, just when an idea is about to be found out as a hopeless failure in the US, public service bureaucrats and politicians in the UK are promising to introduce it to the British public. 

I read that there are anecdotal stories of new business owners being practically begged by SPAC fund promoters to ‘allow’ themselves to be bought and “IPO’d”.  The flop of the Deliveroo market listing in the UK, because UK investment institutions make annoyingly sensible judgements has resulted in observations about the Americans being happy to take more risk (for that, I would translate ‘are more gullible’).

Balancing this up is the recent evidence that of late even in the USA IPO share prices are no longer going to immediate premiums but in the main falling back into losses very quickly.  So maybe credibility is wearing thin even Stateside?

Basically, far too much cash is being pumped around to enrich a small unscrupulous segment of humanity. This is not just in SPAC fund raising, but everywhere in the market where someone else’s money can be used to turn a quick buck or million. That can only end in extra regulations or a crash, or both.

China is a hot topic and risk has become more apparent for investors

It is almost impossible to read serious content from a news or other media source at the moment without finding opinion, research or polemic about China.  This commentary comes from many angles, mainly geopolitical: the seriously concerning reports of concentration camps and maybe even genocide of Uighurs, the crushing of any semblance of democracy in Hong Kong, threats to Taiwan, the creeping influence from the “belt and road” initiative, the activities of Chinese military hacker units and so on.

The above all concern me, but from a purely investment point of view, one has to expect China to become ever more important as a place of massive economic activity, with the tricky combination of gigantic consumer markets, huge enterprises, but the ever-present threat of state control.

It seems to me that the investments we probably all have in businesses like Alibaba and Tencent are riskier than we may have thought and we probably did not get them by electing to invest in China, but by picking Asia Pacific, Technology, Emerging Markets and other ‘global’ badged funds.

One way of controlling that risk might be to invest in funds that focus on businesses selling to the ever-growing Chinese consumer base, but which are not Chinese companies – see my comments right at the end. 

A tangential point is that US policy has been hostile to Chinese investors for some time now, forcing Chinese owners to disinvest from American businesses.  I wonder where they might be re-investing? 

Somewhere where the politics tends to be more waffle and the regulator is known to be permanently looking the wrong way?  Answers on a (small) postcard, anyone?

How much debt is funding equity markets?

The collapse of a US based hedge fund that had borrowed vast sums from an assortment of banks that appear not to have known that they were not a sole lender has caused a flutter in markets because the shares being used as collateral for the ‘punts’ of the particular, apparently not very respectable, hedge fund operator were dumped in the market as the banks tried to be first to get what money back that they might.

This might be a ‘one off’ but it could be a signal of underlying issues of some magnitude.  If that were to be true, a 2007/8 like chain of events might be about to come to our screens as a sequel – sort of “Bear Stearns 2 – the bankers never learn”. Almost poetic.

Digging Deeper

Emerging Markets – not so emerging?

Emerging markets investment has been something that I introduced my clients to when I was working as an IFA, now maybe some 30 years ago, even before anyone talked about “BRICS” or thought it would be possible to invest in China.  One of the first funds I ever recommended was the JP Morgan Emerging Markets fund and that is still going strong.  The Templeton Emerging Markets Investment Trust was launched in 1989 and was run for some years by the legendary Dr. Mark Mobius, who was bold enough to venture into Russian oil company shares and act as main board director of a leading Russian oil company after the end of the Soviet Union, amongst many other forward looking decisions.

Since then some of the countries that one might have automatically assessed as eligible for an emerging markets fund have very large economies and are the bases of some truly global size businesses – South Korea being an obvious example. China will also be the home market of many companies in emerging market funds, even if the shares are listed on Western stock exchanges, with businesses like Alibaba, Tencent and AIA insurance (Hong Kong based) appearing in funds top 10 holdings almost by default.

Investment in India can also be in businesses that we know are operating extensively in the UK like Tata (owners of Jaguar Land Rover), or ICICI Bank.

Investing in emerging markets is clearly not now what it was in the 1990s.  How can we analyse and break down the potential investment universe?

What do you get in an established emerging markets fund?

Taking the ‘granddaddy’ JPM fund mentioned above as a starting point, Morningstar tells us that the fund’s largest holdings are in Taiwan Semiconductor (8%), Samsung (6%) and Tencent (5%).  So that’s nearly 20% of the fund in 3 large Asia Pacific region companies that might well be top 10 holdings in any Asia Pacific or Technology segment funds.

Trustnet tells us that the fund is 46% Chinese Equities, 15% Indian, 12% Taiwanese and 8% South Korean.  All the other equities, which include a very small Indonesian element come to less than 20% of the fund.  So is Emerging Markets even the right name for this fund? Surely that is more like Asia Pacific? It depends on what you think is the definition of ’emerging’.

Using Trustnet’s fund comparator, I checked this fund’s 3 years historic correlation with one other large Asia Pacific fund and with another Emerging Markets fund that is known for having a slightly different asset mix, both from Fidelity.  Unsurprisingly the correlation between the JPM and Fidelity Emerging Markets funds was 0.95, very high.  But the correlation between the JPM Emerging Markets fund and the Fidelity Asia fund was almost as close at 0.93.  The Fidelity Emerging Markets fund, which has less exposure to China and a notable South African content was 0.94 correlated to the same investment house’s Asian fund!

I added the Aberdeen Standard (ASI) Emerging Markets Equity Income fund to the mix and find that it is less correlated with the Fidelity Asian fund at 0.88.  Selecting funds with an income objective tends to get you less growth stocks and more value shares. However, it also has around 70% of is assets invested in the Asia Pacific region.  The notable difference at present is the ASI fund’s large cash holding. 

I conclude that in selecting a mainstream fund labelled as ’emerging markets’ we may actually just end up buying another slug of the same companies we own in our Asia Pacific funds and duplicate several holdings in our technology and global growth ‘stock picker’ or ESG funds.

Are there new truly emerging markets?

It would seem logical to assume that if a country like South Korea has matured in economic terms such that it no longer seems appropriate to consider it as ‘emerging’ in the sense of being much more exciting and adventurous than say the UK, Western Europe or the USA, there must be other less developed economies where we could take the risk and hope for the rewards of being in at the start of a long term growth cycle. Putting it another way, how do we find the next South Korea?

There are indeed such countries and economies.  I live in one!  Places like the ex-Soviet republics and vassal states are generally classified as Eastern European Emerging Markets. You can think of countries like Poland, the Czech republic, Hungary, Georgia or Kazakstan or even Lithuania, Latvia and Estonia, which have a combined Baltics mini-NASDAQ index.. 

There are long standing funds focusing on Latin America, although they generally invested almost wholly in Mexico and Brazil initially because of those countries having large oil and gas reserves. 

There are ‘frontier market’ funds with scope to invest in Africa (although this is a segment better served with investment trusts) and there are countries on the Pacific rim that are ‘up and coming’ like Vietnam or Cambodia and also India’s neighbours in Pakistan and Bangladesh. There are several states in the Middle East with recognised regulated stock exchanges, including the wealthy Emirates.

There are at least 2 ETFs tracking indices or baskets of shares from these regions. The iShares MSCI Frontier 100 ETF is one such with holdings in 13 countries, the top weighting being to Kuwait.

But they will be more risky, surely?

Indeed, and in several ways.

• Firstly, there will be additional higher volatility currency risks (although not in all cases – the Baltic States use the Euro, for example).
• There will be liquidity risks: many of these markets have few shares listed and not many market makers.  Some will not even have a conventional stock exchange. In theory those risks are reduced if you own an ETF as opposed to funds, because the ETF should be liquid at all times, but that is very much ‘in theory’!
• There are risks in assessing value.  Accounting data may be poor or suspect.  Corruption is a problem in every market of the world, but undoubtedly more of an issue in poorer economies.
• There could be extended political risk.  Investing in China will often make one a co-investor with the government and as Mr. Jack Ma found out recently, the Chinese state only allows capitalism to run as far as suits its purpose.  In other countries, the state may just nationalize an asset without compensation.  Having said that the Russian Federation once nationalized an oil company (indirectly) to protect Western investors from a predatory and supposedly criminal oligarch’s banditry!

These are just some of the obvious additional risks.  The fund information documents give potential investors more expanded risk warnings.

However, if we are looking for something that will be a small satellite holding and where we want to be in ‘at the start’, we might find those risks to be acceptable, given a good fund manager to at least keep an eye on them.

It is also worth pointing out that some markets are in reality less risky than people anticipate.  Only when they visit the countries of former Yugoslavia, the Baltic states or the countries of middle Europe do people fully realise that these are countries that have very long ‘first world’ fully European histories that were simply put on hold for a century by the Communist experiment.  Many are very rapidly accelerating their financial and technological development ahead of Western European ‘fat cat’ counties. 

In the same way that China became a manufacturing base for Japan, Eastern Europe is becoming a major factory outsource for Germany and a huge retail market for Italy, for example. There are even some home industries that have become highly successful with or without Western European investment – Škoda cars for example (a divison of VW) or EXSPLA lasers in Lithuania – a supplier to 76 of the world’s top 100 universities.

Some examples of alternative (less Asia Pacific biased) emerging market funds

Readers know very well that I don’t make recommendations and most of you have had some guidance from me in doing your own research, so this little list should only be taken as an appetizer to tempt you into some research of your own. I would not even say that I personally would necessarily buy any of them, although I do already own an Emerging Europe fund (managed by my Swedish bank, so not available in the UK).

One difficulty in researching this sort of alternative merging markets fund is that post Brexit, many fund managers will have domiciled their funds in Europe to get a broader market exposure, UK based buyers of such specialty funds being not that numerous!  For this reason, I am listing funds that are more likely to be on offer on UK dealing platforms (but you need to check that out!)

Barings Eastern Europe Fund

An old stager in this market, not the best performer relative to the MSCI Emerging Europe benchmark over the long run, but has had good spells.  A diverse management team with some names in it that suggest local knowledge!

Jupiter Emerging European Opportunities

When this fund launched I was taken aback by the confidence and rigorous presentation from the then manager (long since moved on), who was Latvian. I never thought that I would one day treat a trip to Latvia much as I used to view a drive to Cornwall or the Yorkshire moors!

This is a value biased fund with maximum holdings in Lukoil (a very Western style Russian oil company) and Gazprom (a Russian government co-shareholding).  The holding in Sberbank at number 3 is interesting as this is a company that might one day be in Russia what Alphabet or Facebook are in the USA.  Recent performance is poor and you would have to be looking for an exposure to a rising oil price to invest here, or see contrarian merits in the shareholdings.

Templeton Frontier Markets

This fund has a miniscule GBP fund class, suggesting no recognition in the UK, although I can easily buy it in Lithuania. The base currency is US dollars.  It is Luxemburg listed.  The fund has run since 2008 and Templeton have a long, almost legendary history as pioneers in emerging market investments thanks to Mark Mobius.  The fund has a large weighting in Vietnam and genuinely looks like emerging markets funds did 30 odd years back!  If you want to be a ‘leading edge’ investor, this might appeal to you but it is right at the top of the funds’ risk scale.

Schroder Small Cap Discovery

This is not specifically an emerging markets fund, but its holdings result in it being classified as such by Morningstar. It has an Asian Pacific bias too but does not have the ‘usual suspects’ in its top 10 holdings.  Recent performance is strong.  On the negative side, correlation with mainstream emerging market funds looks to be quite high.

Morgan Stanley Global Brands

This is a ‘left field’ suggestion.  If one thinks that capitalism has for most of the last century been sustained by rampant consumerism (I do), then one picks investments that will benefit from the direction of consumer spending.  There is a well-rehearsed and evidence-based argument that the huge populations of China and India include a very large new middle class that like Western brands, or at least prestigious products (like the rest of us!).

I therefore suggest that one can invest in emerging markets not only as the economies that will produce low-cost goods for global markets, but as economies that will consume high value goods – in quantity, just because the populations are so large.

Sad to say, perhaps, but regulation is also usually weaker in such places and US companies in particular (not to say Brits or Europeans are paragons of virtue) are expert at the use and abuse of marketing to achieve profit maximization when there are no holds barred.  I say this from direct experience because when I visited South Africa in 1996 just after the end of Apartheid I discovered that British American Tobacco trained and paid attractive young women to give away cigarettes to teenagers in shopping centres. 

So, if your conscience allows it, you can secure your exposure to emerging markets as an investment theme, not by investing in semi-conductor production or T-shirt making, but in whisky, perfume and Mini Cooper sales.