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Sunday, October 24, 2010

Performance Chasing...Probably But If Not Investors May Be Making a Good Reallocation in their Portfolios


The latest mutual fund data on cash flows has been released and (surprise) they show investors,  both individual and institutional, are performance chasing pouring money into the highest performing sector emerging market stocks

from the wsj
Fund managers have regained risk appetite, but still lack conviction about positive momentum in U.S. stocks, according to survey results released Tuesday by Bank of America Merrill Lynch.
The survey found that asset manager risk tolerance jumped this month by the biggest margin since April 2009, with the proportion of fund managers "overweight" on stocks tripling to 27%, from just 10% in September. However, the drive for stocks is being driven by global emerging markets. Nearly half of asset managers are sitting heavy in emerging-market equities, according to the survey.
Among diversified global equity ETFs, which primarily invest worldwide equity securities but can include shares of U.S. companies, the Vanguard Emerging Markets Stock ETF has expanded the most. Inflows into the ETF have raised total assets by $15.7 billion, or 39%, this year. The iShares MSCI Emerging Markets Index Fund has taken in close to $4 billion, or 8.2%, in assets. Meanwhile, the SPDR S&P 500 ETF, a fund that mirrors the U.S. benchmark index, has shed $5.6 billion in funds, or 6.7% in assets.
The trend has to do with outperformance of non-U.S. stocks, but also is "a recognition of what came to light during the 2008 financial crisis, that the financial system in developed countries is not necessarily any better or less risky than in emerging markets," said Gregg Wolper, senior analyst at Morningstar. "Add in concerns with dollar weakness and it's reason to look elsewhere."
While investors may be engaging in a great deal of performance chasing here there may be some good rationales for these flows, provided they represent a long term change in asset allocation rather than simply a short term portfolio shift. US investors both institutional and individual have long showed a "home bias" keeping too much of their investments in US stocks. US stocks make up around 44% of world market capitalization so those investing in only US stocks are missing a measure of diversification. This is the case even taking into account that many of the largest US corporations generate much of their income from abroad.

But even making use of the standard indices for allocating assets outside of the US is likely not the best strategy. Those indices (and the etfs that track them) reflect the capitalization of world stock markets and thus are tilted sharply towards the developed market economies which have a high proportion of their firms listed on public equity markets. Those countries with the highest market capitalization get the highest weightings, while emerging markets whose equity capitalization is relatively smaller have low weightings. As world economic growth has shifted the world equity market capitalization less and less represents a measure of the world economy, a trend that is likely to continue.

An alternative approach to international allocation would be a GDP weighted index which sets the country allocation based on relative weight in the world economy. Such an index exists the MSCI GDP Weighted Index, although as of yet there is no etf or mutual fund based on it.  This is in a way analogous to the various times of "fundamental indexing" strategies that use methodologies based on critieria other than market capitalization in weighting their holdings

As MSCI writes

An Alternative to Market Capitalization Weighted Indices for Global Markets

The MSCI GDP Weighted Indices are designed to reflect the size of a country’s economy rather than the size of its equity market by using country weights based on a country’s gross domestic product (GDP).  Some investment professionals prefer to weight countries in a regional index by GDP rather than by market capitalization because:
  • GDP figures tend to be more stable over time compared to equity markets’ performance-related peaks and troughs
  • GDP weighted asset allocation tends to have higher exposure to countries with above average economic growth, such as emerging markets
  • GDP weighted indices may underweight countries with relatively high valuation, compared to market-cap weight indices.
Largest Absolute Weight Difference Between the Standard Market Capitalization Weighted MSCI ACWI and its GDP-Weighted Equivalent
CountryMarket-cap WeightedGDP WeightedWeight Difference(GDP-Market Cap)
United Kingdom8.11%4.10%-4.01%
United States44.39%26.76%-17.63%
Data as of June 1, 2009
The largest overweight countries in the MSCI ACWI GDP Weighted Index are classified as emerging markets, such as China, Brazil, India, Russia and Mexico, which are some of the fastest growing economies but have market capitalization weights that are smaller than their economic weights.
However, the list of over weighted countries also includes some developed markets, such as Germany and Italy.
The US and the UK have the largest disparity in size between their substantial market cap weights and their smaller economic weights.

Key Benefits
  • Alternative Approach to Capturing the Country Factor
  • Relevant Benchmark for GDP Weighted Asset Allocation
  • Broad Country Coverage

a research report from MSCI is here:
Thus there is in my view a strong argument for investors to increase their holdings in emerging markets based on the current composition of the world economy. In addition the following factors argue for such an increased relative weighting :

  1. Unlike during earlier boom periods for emerging markets, the growth in these countries is not funded primarrily with foreign borrowing.
  2. The growth of the middle class in these countries should fuel domestic demand and make these countries less dependent on exports to the developed world a trend likely to accelerate
  3. The demographic "bubble " in these countries is younger thus skewed to populations likely to increase spending and savings in the future. At the same time the demographic "bubble" in the developed world will be increasingly those withdrawing savings from public and private pension and retirement savings.
  4. The growth of the middle class will mean more savings and thus more funds to be allocated to local equity investments. Retail investing is at its infancy in much of the emerging markets.
  5. As these economies become more sophisticated more corporations will go public and the relative market capitalization of these countries will increase in world indices. Thus those that invest based on gdp weighting will be "ahead of the curve" relative to cap weighted international investors.
All of these trends mean that the future weighting of emerging markets on both a relative gdp and relative cap weighted basis will increase in the future. And all of this argues for a greater weighting in emerging markets than that dictated in a cap weighted index, greater than that in most US portfolios. There is certainly a strategic move being made by institutional investors worldwide into emerging markets which will help these markets. No doubt there is still the risk of hot money flowing in and out and there is not much to the argument of "decoupling" of the emerging market stock markets to the rest of the world, correlations are likely to remain high. But correlation does not mean there will be no outperformance, it simply means that both markets will move in the same direction at the same time.

Here is a chart of the correlation between the US total stock market (VTI) and emerging markets (EEM), over the past two years the correlation is very high.

  And here is a chart of the returns over the same period (emerging in blue). The two move in the same direction, but the difference in performance is enormous.

In both my client and personal portfolios my weighting for emerging markets in the international portion of their equity holdings is significantly larger than the 26.6% that is the weighting for emerging markets in the cap weighted world ex US etf (VEU). Making use of both the emerging markets index VWO and the emerging asia etf (GMF) the international allocation is tilted more towards emerging and more towards emerging asia than the VEU and for that matter more towards asia than the cap weighted VWO. I have kept to the allocation  except to rebalance to the target allocation.

If the investor flows into emerging markets represents a strategic reallocation of equity portfolios so that the portfolios have more international holdings and less of a home bias reflecting world market capitalization, world gdp weightings and/or trends for long term economic growth I would view it positively.

Unfortunately, based on our knowledge of investor behavior and of past flows in and out of emerging markets ,this data probably represents a large amount of hot money chasing performance. As is usually the case it will likely run the minute there is a selloff invariably buying high and selling low .

If there is good news in this it is that these flows can work to the advantage of the long term investor who rebalances to keep to his asset allocation. That investor can gain from the "rebalancing premium" when he sells a bit of his holdings to get back to the target allocation and buys back to get to the target allocation when the inevitable short term sellof pushes his holdings below the target allocation. Unlike the market chaser, the rebalancer is selling high and buying low. In fact the rebalancer actually picks up a bit in portfolio performance due to the volatility caused by the hot money (the rebalancing premium). It's not hard to envision that this has occurred numerous times in the volatile emerging markets where short term moves of 20% are not infrequent:

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