Emerging Markets: Bubble or On the Way to a Return to Trendline ?

Perhaps the bubble type activity was on the downside as emerging markets plunged in sympathy with the US and developed markets . The markets were not decoupled but looking at economic performance in the past year the growth stories seem to be decoupled.

Overdone on the upside or just reverting to the long term trend ?

The second graph shows inflows into emerging markets mutual funds and remember that is only a fraction of the inflows into emerging markets

Not A Good Explanation for The Emerging Market Rally And I Am Not At All Sure It's A "Bubble"

Jason Zweig in the WSJ presents the argument that money flowing mindlessly into the emerging markets etfs is responsible for a bubble in those markets. As I will show not only is that argument not persuasive, the entire argument that these markets are in a bubble should be regarded with skepticism.

My bolds and italics


Are ETFs Causing an Emerging-Markets Bubble?
• By JASON ZWEIG



U.S. investors have pumped roughly $26 billion into emerging-markets funds so far this year. Of that, $15 billion came in through exchange-traded funds -- portfolios that hold every stock in a market benchmark with utterly no regard to price.

Several hedge-fund managers and other active stockpickers have told me that this "mindless money" is distorting valuations and pumping up a potentially monstrous bubble.

First off note that 42% of the money flowing from US investors into emerging markets went into active funds, add in cross border flows into emerging markets from the rest of the world and local investors in those markets and I would be shocked if US etf inflows represented more than 50% of new inflows into developing markets. Global cross border inflows into emerging market funds were $80 billion, add in hedge funds, pension funds, cross border flows within the emerging markets and local investments into home markets and that etf inflow starts to look very small.


Courtesy of Investment News here (next paragraph) is a list of institutions that have added to their emerging markets holdings as of late I would assume only a small percentage went into the emerging markets etfs, and I think it is safe to say that the new investment by these institutions (and there are many many others) dwarfs the $15 billion into etfs. Even if the market runup is due to "mindless buying" it seems more likely it is not buying of the emerging market etf.

Some funds that have added exposure to emerging markets in the past year include the 2.5 trillion Norwegian-kroner ($448 billion) Government Pension Fund-Global; the 64.25 billion Australian-dollar ($59.3 billion) Future Fund; the Ilmarinen Mutual Pension Insurance Co. of Finland, a 21.6-billion-euro ($32.2 billion) multiemployer pension fund; the $23 billion Arizona State Retirement System; the 7-billion-pound ($11.6 billion) West Midlands Pension Fund; and the Vermont Pension Investment Committee, which oversees the state's funds, including the $1.5 billion State Teachers Retirement System and the $1.3 billion State Employees' Retirement System.
The $201.1 billion California Public Employees' Retirement System is in the middle of a broader review of its global-equity portfolio, which accounted for 51.7% of total assets as of July 31.

more from zweig:

"At first blush, it is hard to imagine that they are wrong. As money pours into the ETFs, they must mechanically match their holdings to those in the emerging-market indexes. That forced buying drives up stock prices, attracting still more new money into the ETFs, spiraling stock prices even higher."

Actually market performance in emerging markets calls the above in question. If it were really market cap weighted index buying that was "mindlessly" driving up the value of stocks in the index, then those stocks with large weignts in the index would have grown in value far more than those stocks with very low weights in the index.

But that is not at all the case. and we have a point of comparison. Dimemensional Funds (DFA) has an indexed fund which holds small cap emerging market stocks (DEMSX), precisely those that have a low weight in a market cap weighted etf like EEM. That fund is up 90.1% ytd vs 65.13% for eem. If there is "mindless buying of emerging market stocks" maybe its the small caps. (bar chart)

In fact Zweig is more skeptical of the bubble argument although the does warn of the narrowness of some of the indices.:
.

But that is nothing new. Some emerging-market ETFs invest in indexes that are so concentrated that they mightn't fully reflect the real economy. The Brazilian market "has been top-heavy for years," says Dina Ting, who manages the iShares MSCI Brazil ETF. "There's two big companies, and then the stocks just fall off a cliff in terms of size." Indeed, at the end of 2007, according to data from MSCI, Petrobras and Vale together constituted 50.3% of the index -- a much greater share than today. And the two companies traded at much higher multiples of their earnings and assets in 2007 than they do now.

(which should either argue that the concentration risk has diminished or that it didnt particularly impact returns in the past,

Furthermore, even if emerging-market ETFs have contributed marginally to the boom with their forced buying, some may soon become forced sellers.
Thanks to obscure provisions of the U.S. Internal Revenue Code and the Investment Company Act of 1940, which governs how mutual funds are organized, ETFs can't allow their assets to become over-concentrated in a handful of holdings. In general, they can't keep more than 25% of their money in a single stock, and at least half of their assets must be in securities that each account for no more than 5% of total holdings.
Now that emerging markets have risen so far so fast, these tax requirements may compel some large ETFs to begin selling their biggest holdings.

So what does all this mean for investors? ETFs probably haven't caused a bubble, and they might even help a bit to prevent one from forming. But many will remain superconcentrated bets on very risky markets. If you invest in an ETF with most of its assets in a few stocks and think you have made a diversified bet, the real bubble is the one between your own ears.

But if emerging markets etfs contribute marginally to the boom, why would one expect their forced selling to have more than marginal impact when they sell


In fact the argument against a bubble in emerging markets can be made on several counts:

valuation: as investment news notes:

Vinicius Silva, an analyst at Morgan Stanley, calculates that emerging markets are trading at 12.9 times their expected earnings over the next year. Since 1993, that average has been 12.8 times earninngs. Emerging markets as a whole are neither a bubble or a bargain.

In fact if one assumes emerging market gdp and thus earnings is accelerating it would seem to me a premium over the average p/e since 1993 is justified.

emerging markets as a % of world market cap. As the bar chart shows this % has been growing steadily (24% in this measure). Relative to market cap US investors are significantly underweighted in emerging markets and the slower they are to put new money in the further underweighted they will become. Using a % of world GDP as a measure the underweighting is even more significant, And I would suspect individual investors as a whole are in the same position. Top left chart (click to enlarge the bar of emerging as % of world market cap)

Investment News reports :

some consultants and money managers think that pension funds still have a long way to go and need to in-crease those allocations closer to 35% of total assets — or roughly the weighting of emerging markets in the global economy — from the current allocation of about 5% or less for the average fund.
“Where pension funds are [invested in emerging markets], relative to where they should be, is a massive underweight position,” said Jerome Booth, head of research and a member of the investment committee at Ashmore Investment Management Ltd. “This reality has been true for a while, but the credit crunch has made it much more obvious.”

So it is not surprising to see the chart (posted separately) of net flows into emerging markets. A bubble or a long overdue global allocation based on changes in the world economy.

Finally a look at this long term chart of eem may indicate that rather than a bubble on the upside this year, the markets experienced panic selling in a downside bubble last year and now are returning to a long term trendline of growth. (see nov 11 entry)

In sum I would hesitate to label the emerging markets rally this year a bubble despite the eye popping returns. Valuation, economic growth and money flows seem to justify a strong market. But emerging markets are always volatile and not for the fainthearted.

Putnam Investments Has Quite A Deal For You....

I have been looking into the newest product/gimmick from Putnam Investments, their absolute return funds, These funds are designed to produce a targeted return over inflation as represented by the till rate. The target returns are 1% 3% 5% and 7%.

I'll have more to say about this fund in a later post but the unattractiveness of the 100 fund is apparent based on the fees alone. This fund which has a target return of 1% above tbills is 71% cash equivalents and carries a management fee of 1.25%.

Let's count the cash equivalent portion as virtually the same as a money market fund.
With 71% of the portfolio in cash and multiplying the management fee of 1.25% by 71% that means you are paying a management fee of .89% (.71x 1.25%) which is obviously outrageously high and figure the other 29% of the assets which are all bonds is the equivalent of a bond fund that part of the portfolio carries and effective management fee of .53%(.29x 1.85) not terrible but not very attractive compared to the vanguard short term bond etf fee of .11%.

so an investor could create a portfolio that would perform in pretty much the same manner with 2 holdings

a low cost money fund (vanguard's is .14%(
a short term bond etf (etfs as low as .11%)

so the portfolion would have a blended management fee of .12% ! (.71x.14% +.29x.11%)

Oh, and just to "sweeten" the deal for investors, this fund carries sales charges. The A shares with the 1.25% operating expenses have an intial sales charge (front end load) of 3.25%. That means of every $100 invested $3.25 goes out in a sales charge. Which actually means that in the first year of any investment the it is impossible under current market conditions to provide a net return to investors of 1% above inflation as represented by tbills.

Here's the math

90 day tbill rate .07%
1% return above tbill 1.07%

so the value after one year on an investment in the fund after deducting sales charges is 97.43 or a loss of 2.57%. If you do the math you can see that the tbill rate has to rise to 2.25% to even breakeven with this fund.


It seems the putnam 100 is one to just say no to. Putnam funds are only available through financial advisors. Needless to say I have great problems with any advisor that would recommend this fund.

more later

Morningstar Tells Us (Again) That Their Ratings Have No Predictive Power But Some People Never Seem to Listen

The WSJ carries an interesting but strange article about an adviser who "bucked the trend" by investing in a mutual fund rated with only one star from Morningstar. The interesting thing to me is that this "investment professional" would take the morningstar rating as a serious input into the portfolio allocation. It is also disappointing that the WSJ would think it newsworthy that the morninstar ratings are useless in predicting future performance. The head of morningstar's mutual fund research makes this clear in the article and a careful reader of material from morningstar for years (as well as academic research) would have know this for at least a decade.

This still doesn't stop many of my colleagues from using morningstar software called principia and screening for funds with high "star ratings' when constructing portfolios. In my portfolios I only use index funds or etfs and I never check their ratings although I may compare those index investment vehicles in the same asset class with regards to fees and index methodology.

My bolds and italics



A Financial Adviser Bucks Star Power
Morningstar Is Just a Guide, He Says

By DAISY MAXEY
When David Kudla, chief investment strategist at Mainstay Capital Management, added a mutual fund that had been given a Morningstar rating of just one star to clients' portfolios last December, some called to question his decision.

DAVID KUDLA
"Some were appalled by it," Mr. Kudla said of his adding White Oak Select Growth (trading symbol WOGSX), which then carried Morningstar's lowest rating, to some of the financial-advisory firm's accounts.
He chose the fund because Mainstay expected technology, in which the White Oak fund is heavily weighted, to be among the sectors performing well in 2009, said Mr. Kudla, also the company's chief executive.

...

I'm not sure that if the above was one's outlook the more appropriate decision would be to add weighting of technology through an allocation to one of the technology etfs with style purity and lower fees.

Mr. Kudla says the fund's performance and rating underscore an important point: Morningstar ratings can be especially misleading at market inflection points.
"A rating based on the performance of an aggressive-growth equity fund, which includes the worst bear market since the Great Depression, was not a good indicator of how that fund was about to perform in 2009," he said. Mr. Kudla takes Morningstar ratings into consideration, but only as one factor among many

.....

and here is the quote from morningstar treated as if it is a new revelation or admission when in fact it has been stated numerous times over the year (although I would be the first to admit morningstar does give mixed messages.

Russel Kinnel, director of mutual-fund research at Morningstar, said the ratings are meant as a quick summary of past risk-adjusted performance and don't have "any great predictive power." Morningstar has found, however, that five-star funds generally perform better than one-star funds, and that the ratings are more predictive when there is a "smoother patch" in stock-market volatility, he said.
The ratings can be a good way to quickly check a portfolio, Mr. Kinnel said. "If a fund is one star, you'd want to know why it's doing so poorly; there could be a good reason," he said. In contrast, Morningstar's analyst "picks and pans" indicate which funds the investment-research firm's analysts believe investors should and shouldn't buy, he said

I'm not sure about the picks and pans either both because I haven't seen any data with their track record and because Morningstar gioves a mixed message on picks and pans since some of the picks are active funds but morningstar consistently speaks positively about the advantages of index instruments over actively managed mutual funds

Inverse Etfs....As I Was Saying

The WSJ's James Stewart may be a bit confused about them (see oct 29 blog entry), but the FT is quite clear on how imperfect a hedge vehicle they are: my bolds and italics

Upside-down’ investors may not see risks
By Sophia Grene

Index tracking or passive investment is now well established as a sensible form of investing. But what if you believe the index in question is likely to fall? Or you think it will rise and you want to exploit your belief to the utmost?

For investors with those beliefs, there are inverse and leveraged indices. Although these sound straightforward – just take an index and turn it upside down! – it does not work quite as simply as that.

An inverse index is constructed by calculating the return of an index, including price movements and dividends, then reversing it. They are most often used as the underlying index for an exchange traded fund, and many investors see them as an alternative to shorting an index. This is particularly useful for those whose investment mandates do not allow them to short directly, just as a leveraged index ETF, which offers multiples of an index’s returns, directly or inverse, gets around restrictions on leverage.......


However, regulators are now looking closely at how they function and whether they are being properly represented to investors.

Almost all of the inverse products rebalance daily, which is no problem if the market is moving smoothly in one direction. More volatility makes it more complicated, as daily rebalancing means the inverse index returns can veer far away from the return one might expect with a naïve calculation of the return of the long-only index and finding its inverse.

If a long only index declines by 10 per cent over a year, an unsophisticated investor might expect to receive a 10 per cent gain from an inverse index ETF.(take note Mr, Stewart of the WSJ) This is relatively unlikely, as the index returns only the inverse of each day’s return, rather than that of a year’s return. ...

In the US, the Financial Industry Regulatory Authority (Finra), the largest independent regulator for US securities companies, warned in June that these products were not suitable for retail investors who plan to hold them for more than one trading session.....

In July, UBS suspended sales of inverse and leveraged ETFs in the US, explaining in an official statement that “the short-term nature of these securities is generally inconsistent with the long-term view of investing that UBS advocates when building client portfolios”.

Maybe some wsj readers are UBS clients and therefore will be saved the opportunity to replicare Mr. Stewart's "experiment:.

interesting graphs

 

from a recent FT article. The really interesting graph is the center one which shows housing prices as a percentage of household income. Note how high the current level still is.

Housing is highly sensitive to changes in interest rates, Few people think mortgage rates will fall in the near future from their historically low levels (aided by current fed policy). At a mortgage level of 6% housing has generally been priced at
1.4 to 1.5x household income vs the current 1.9x.

I don't make forecasts here but it is hard to see how we have reached the long term bottom in housing prices.

Just Like in Lake Wobegon Where Every Child Is Above Average

"Top Money Managers" self report their performance to Barrons and over 70% are above average: