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Fund Manager Selection in Emerging Markets


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Presentation prepared by LMG Emerge for the Sep 26-28 2011 Fund Manager Selection conference in Zurich, Switzerland.

It explains why selecting the right fund manager in Emerging Markets is not easy, but definitely not impossible either.

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Fund Manager Selection in Emerging Markets

  1. 1. Fund Manager Selection in Emerging Markets<br />by Erik L van Dijk, LMG Emerge<br />
  2. 2. Page 2<br />Table of contents <br />Alpha Generation and Portfolio Optimization: Selecting EM/FM Managers<br />Introduction: The World Has Changed<br />1<br />A New Balance of Power in International Capital Markets<br />2<br />EM and FM: Not a one-size-fits-all bloc<br />3<br />Man Selection 1: The Benefits of Local Knowledge<br />4<br />5<br />Man Selection 2: Manager Due Diligence and Monitoring<br />Man Selection 3: Combining Managers<br />6<br />Evaluation<br />7<br />
  3. 3. Page 3<br />1.1 Introduction: The World Has Changed I<br />Up until the 1990s Emerging Markets as a group did not really outperform developed markets in a structural manner<br />True, there were great periods and individual countries with strong developments, but sooner or later negative surprises in combination with excess volatility / risk would cause disappointments<br />But since the beginning of this century things seem to be different, with the BRIC nations developing into a true global growth catalyst.<br />This has also positively affected growth in other Emerging and Frontier Nations (compare for instance GSAM‘s Next-11 concept)<br />
  4. 4. Page 4<br />1.2 Introduction: The World Has Changed II<br />When looking at the available production factors, we see that:<br />Situation in Developed Nations has deteriorated<br />Situation in Emerging Countries has grown better<br />Globalization works as a catalyst for this trend<br />Energy situation is most worrisome when comparing prod. factors<br />
  5. 5. Page 5<br />2.1 A New Balance of Power in International Capital Markets<br />Globalization , ‘Securitization’, Demographics, Geopolitical Factors and Diversification have changed the balance of power in international capital markets <br />Relative financial advantage of Developed Nations at the government level has deteriorated<br />Larger role for institutional investors and sovereign wealth funds<br />Growing interest in foreign direct investments and cross-border portfolio investments<br />Reduced dependence of Emerging Nations on loans from banks<br />Dambisa Moyo & Muhamad Yunus/Micro Finance Movement: Economic Support instead of (Dead) Aid<br />And let’s not forget: to a large extent it is mean-reversion back to a situation similar to the one before the Industrial Revolution!<br />
  6. 6. Page 6<br />2.2a The ‘Old World’ of the Large Institutional Investors<br />Based on market values of investable assets<br />
  7. 7. Page 7<br />2.2b The New ‘Three Bloc World’<br />Distribution of Global Wealth based on GDP<br />
  8. 8. Page 8<br />2.3a Institutional Investors: Almost USD 20 trillion available<br />Institutional Investors<br /><ul><li>Western Pension Plans still dominate
  9. 9. But Sovereign Wealth Funds grow faster
  10. 10. Demographics work against Pension Plans
  11. 11. LT Goals of SWFs give them the opportunity to achieve higher growth rates</li></li></ul><li>Page 9<br />2.3b Institutional Investors: SWF’s mainly an EM phenomenon<br />Sov Wealth Funds<br /><ul><li>Asia and Middle East dominate
  12. 12. Energy Wealth and Excess Economic Growth
  13. 13. SWF’s Oil and Gas related Wealth = 60 percent; other 40 percent</li></li></ul><li>Page 10<br />2.3c The World’s Largest SWFs<br />
  14. 14. Page 11<br />2.4a Total Returns ($) 2001-2011 – Developed Markets<br /><ul><li>Relatively poor 10-year period, with a disastrous 2008-2011
  15. 15. Larger firms most affected
  16. 16. The US ‘sneezing’ but Europe very ill.
  17. 17. Small-caps did reasonably well.
  18. 18. ‘Financials’ explain a large part of the problems in Developed Markets (see Sector chart 2.4c)</li></li></ul><li>Page 12<br />2.4b Total Returns ($) 2001-2011 – Emerging Markets<br /><ul><li>Contrary to Developed Markets, EMs doing well
  19. 19. Recovery after GFC
  20. 20. Small firm premium much less clear and stable
  21. 21. But do not refrain from small-caps since the pool of small-cap stocks contains a substantial part of overall liquidity
  22. 22. After such a strong period overheating? Expand universe to include Frontier Markets</li></li></ul><li>Page 13<br />2.4c Total Returns ($) 2001-2011 – Sectoral Analysis<br /><ul><li>The story of the decade is the demise of the business model of Developed Markets financials
  23. 23. EM’s outperform in all sectors. Playing the small-cap ‘game’ important but more complicated in EM space</li></li></ul><li>Page 14<br />2.5 Trends in Money Flows<br />Within the new three-bloc world order we can expect the following trends:<br />Structural – but volatile - long-term inflow of portfolio investment capital into EM and FM countries<br />Structural – but less volatile – growth in Foreign Direct Investments in EM and FM countries<br />Tensions when large EM and FM corporations and investors want to expand in Developed Countries<br />Geopolitical nervousness<br />Within EM and FM shifts (= changing comparative advantages)<br />Commodity Producers versus Consumers<br />Development of the Financial Services Sector<br />Development of Domestic Consumer Markets<br />‘Africa Middle East’? And ‘Asia from Emerging to Developed?’<br />
  24. 24. Page 15<br />3.1 EM and FM: Not a one-size-fits-all bloc<br />We often talk in detail about differences between Developed Markets, but then proceed talking about EM/FM as if it is a homogeneous bloc.<br />This is wrong!<br />Enormous wealth differences<br />Commodity-rich versus commodity-poor (see Energy example 3.2)<br />Huge differences in legal and political systems<br />Diversified in terms of level of integration with world economy<br />Average growth level of GDP high, but large differences exist<br />Differences in quality infrastructure (including financial and/or legal!) are large<br />
  25. 25. Page 16<br />3.2 Energy Winners vs Losers: Important distinguishing factor in the 2011-2021 decade<br /><ul><li> Ideas to remove RUS from BRIC do totally forget the energy situation; if anything we have to worry about BRA first.
  26. 26. Developed nations in Europe and Japan most endangered
  27. 27. Energy Risk in EM’s less of a problem than in Developed Markets
  28. 28. Increased investments in Renewable Energy and Nuclear Energy a MUST for many countries</li></li></ul><li>Page 17<br />3.3 EM/FM and Style Investing<br />Some core observations and their impact on our ‘standard’ EM/FM investment approach:<br />International investors used to allocate to international specialists and not local providers. <br />This leads to excess interest in large-caps<br />Markets are still treated as extremely risky as a result of which there is too large an interest in ‘excellent’ historical performance charts<br />Panics and re-allocations internationally lead to in- and out-flow rhythm that causes disappointing performance<br />Local specialists are available, but you need to look for them. Big consultants are often way too reluctant allocating to these parties.<br />The more ‘growth’ an economy already is, the more interesting its ‘value’ stocks<br />
  29. 29. Page 18<br />3.4 EM/FM : How to incorporate Style<br /> How ‘Style’ can be incorporated ‘the local investment specialist’ way:<br />Key: Don’t follow the main crowd. <br />The more inefficient a market, the less valuable the information content of what the main crowd is doing.<br />
  30. 30. Page 19<br />4.1 Man Selection 1: Benefits of Local Knowledge<br />Emerging Markets are characterized by Inefficiencies<br />Active, bottom-up management adds value<br />Top-down added value from asset allocation skills and manager selection<br />Emerging Markets are not one homogeneous group of nations<br />Local presence adds value<br />Strategic partnerships<br />LMG: Create a win-win situation for local asset management partners, major institutional partners and clients<br />Better return/risk ratios<br />Entry to Western Institutional Markets for local strategic partners<br />Prestigious seal of approval for local strategic partners<br />
  31. 31. 4.2 Man Selection 1: Finding the right Manager<br />DDQ:<br />35 Attributes and scoring<br />Quant Filter: <br />using our GTAA system as screening device<br />Expected Alpha by manager<br />Initial Meeting<br />Questionnaire & Holdings Analysis<br />On Going Monitoring & Due Diligence<br />On Site Due Diligence<br />Manager Assessment Scoring<br />20<br />
  32. 32. Page 21<br />Step 1<br />Step 2<br />Step 3<br />Step 4<br />Step 5<br />4.3 Man Selection 1: The Manager Selection Cycle<br />The Manager Selection Cycle<br />Ongoing Update and Analysis of Universe of about 1,000 asset managers with EM and FM products<br />Due diligence to find the 25-50 Best-of-Breed product candidates<br />Ongoing learning by doing; <br />Performance Analysis;<br />From Green to Yellow to Red;<br />Replacement Strategy and back to Step 1/2<br />Derivation of a short-list of about 100 managers based on quantitative and qualitative analysis<br />Analyze the selected managers separately and in combination;<br />F-of-F fund creation;<br />Derivation of portfolio weights<br />Includes 300-400 local managers<br />
  33. 33. Page 22<br />4.4 Man Selection 1: Structured Grading System<br />Derivation of the Green, Yellow and Red Cards – Signal Focus<br />Analysis of Manager Performance based on Peer Group comparison using Bottom-up Databases (Camradata, LMG, Morningstar)<br />Analysis of Manager Performance based on relevant Market Trends using the LMG Asset Allocation Framework<br />Market<br />Peer Group<br />Manager<br />Other Factors<br />Client input/veto’s; <br />Other relevant information, including ‘Manager Cycle’ information, Tenure information etc.<br />Analyse Manager’s Performance vis-à-vis expectations in terms of Return-Risk profile; qualitative factors etc.; i.e. Risk Management Focus<br />
  34. 34. Page 23<br />4.5 Man Selection 1: Independent Judgment <br />The Green, Yellow and Red Cards<br />The best managers are selected<br />Timely warnings before performance turns mediocre<br />Performance is monitored and analyzed<br />LMG Ref<br />LMG decides in an independent, quant-qual decision process<br />We say goodbye when we have to say goodbye<br />Backbone Partners<br />enable tough stand<br />
  35. 35. Page 24<br />5.1 Man Selection 2: Due Diligence and Monitoring<br />Due Diligence and Monitoring<br />There are definitely enough local and regional providers with interesting performance<br />Don’t overweigh the value of the old focus on long track records and low tracking errors<br />But make sure to go through a tight due diligence and monitoring regime in which you require them to comply with YOUR rules<br />No compliance? Resistance? Don’t use the manager<br />Be surprised to find out that willingness to comply is far higher than what you might have expected<br />If necessary, require tailor-made solutions and segregated mandates<br />Tight monitoring necessary<br />
  36. 36. Page 25<br />5.2 Man Selection 2: Due Diligence and Monitoring II<br />Top-down asset allocation and country selection of AIM links five regions / 10 strategic markets<br />Concept encompasses the selection of strategic partners per region.<br />Strategic partners have to be best-of-breed in at least two asset classes within their region<br />Output / regional market visions of strategic partners incorporated as signals in our global GTAA approach<br />
  37. 37. Page 26<br />6.1 Man Selection 3: Multi-Manager<br />Global ‘Usual Suspects’ or Multi-Manager<br />Based on LMG’s proprietary database with manager information about some 1,000 managers (of which about 300 locals) we know that there are not many local providers with outside-of-their-regionbest-of-breed products<br />Local managers do however invest differently (bigger focus on smaller securities and out-of-index investments)<br />The style difference and good performance make best-of-breed local providers an interesting alternative for ‘usual suspects’ or at least a nice diversifier<br />Top-down layer to combine these local players has to be added<br />The extra cost layer is more than manageable because the bulk of best-of-breed local providers is willing to cut fees so as to get the prestigious Western client in<br />
  38. 38. Page 27<br />6.2 Man Selection 3: How to Integrate Top-Down and Bottom-Up?<br />EM and FM: Now large enough to be a separate component within asset class mandates. Not just in allocation of mandates, but also ALM.<br /> Bottom-up financial information often less reliable (information scarcity): Integrate top-down and bottom-up with top-down being an important constraint. No excitement about bottom-up stories when they are not more than corroborated by top-down outlook<br /> EM and FM more important in the world? Pay special attention to EM-FM sensitivity of Western Firms:<br />Indirect way of investing in EM-FM wasn’t a good way of capturing the EM-FM component so far, but things are rapidly changing<br />Theme plays (E.g. ‘’Water’’, ‘’Energy’’, ‘’Food/Agriculture’’, ‘Rising Middle Classes in EM-FM’’, ‘’Islamic Finance’’)<br />
  39. 39. Page 28<br />6.3 Man Selection 3: F-of-F Solution in EM Space <br />The Fund-of-Fund Structure<br /><ul><li>Operational Management of the Fund-of-Fund structure
  40. 40. Performance Analysis and Reporting
  41. 41. Marketing of the Best-of-Breed Concept</li></ul>Fund<br />Management<br /><ul><li>Translate Macro Information into the right Within-Fund Manager Mix
  42. 42. Manage the Global EM Portfolio
  43. 43. Balanced Mandates using PROTECTOR</li></ul>Macro Signals<br />Asset Allocation<br />Risk Management<br /><ul><li>Selection of Managers
  44. 44. Cooperation with Bottom-Up Best-of-Breed Partners
  45. 45. Derivation of our Managers’ Macro Signals</li></ul>Selected Managers within Funds<br />Regional, Asset Class and/or Theme Mandates<br />
  46. 46. Page 29<br />6.4 Man Selection 3: Risk<br />EM – FM: Take care of Risk factor<br />Beta and Volatility normally higher<br />More sensitive to changes or surprises in earnings, risk and other fundamental variables (see next sheet 6.5)<br />Lower correlations but globalization and behavior of foreign investors in large caps have led to diminished value of the correlation factor<br />Non-normal distributions: Kurtosis and Skewness are far more important than in developed markets<br />Create a robust, diversified portfolio: transaction costs are often higher and liquidity lower. When you are wrong, there is not much to do but sit and wait.<br />But know that the real GM’s do often make their biggest profits during that sitting and waiting period when panic of others provides them with buying opportunities<br />Beware of Index Biases: a lot of liquidity can be found in the small cap segments of local markets outside of the index universe.<br />Don’t overestimate the value of a reasonably low tracking error at the manager level<br />
  47. 47. Page 30<br />6.5 Man Selection 3: Be Aware of Excess Sensitivity to Surprises<br />An example: Excess Sensitivity to Surprises:<br />Using the Gordon-Shapiro Dividend Discount Model to Derive a Representative Result:<br />BASE DATA EXAMPLE<br />AND SEE HOW SURPRISES IN KEY VARIABLES CAN CHANGE RESULTS<br />Source: LMG Emerge, sensitivies calculated as per granular change in key variable. Paper available by request.<br />
  48. 48. 6.6 Man Selection 3: Portfolio construction <br />Constraint-based ‘’Near-Optimization’’ <br />Excess Return Set<br />Risk Management<br />Outcome<br />BroadOpportunity Set<br />β<br />+<br />+<br />=<br />Consistently strong risk adjusted returns<br />Equity<br />Portfolio Construction<br />Diversification<br />Fixed income<br />Commodities<br />Listed private equity<br />Currency<br />Risk management (VaR, MVaR, Correlation, Conditional Regressions, Political Risk etc.)<br />Hedging strategies<br />Optimisation based on risk budget<br />Listed property<br />Regions<br />Skill<br />α<br />Asset Classes<br />Style<br />Investment Vehicles<br />Arbitrage<br />Asset Allocation<br />External Manager (Mandate permitting)<br />31<br />
  49. 49. Page 32<br />7.1 Evaluation – EM/FM, The Market<br />The Importance of EM-FM is growing and this trend will continue<br />These markets are more inefficient for quite some time to come, with current behavior of large foreign investors leaving a lot of alpha to be captured<br /> Dare to think ‘out-of-today’s-box’: ‘Value’, ‘Overreaction’, Small- and Mid Cap with Top-Down Market-Related factors as constraints<br />Diversify, taking into account risks and excess sensitivity to surprises<br /> Diversification should not just include direct allocations to EM and FM, but Theme Play provides the investor with interesting additional opportunities to optimize his overall performance<br /> Don’t forget Local Asset Managers! They are there!<br />
  50. 50. Page 33<br />7.2 Evaluation – EM/FM, The Managers<br />Emerging Markets are still relatively inefficient. The difference between ‘good’ and ‘mediocre’ asset managers is large<br />Top managers/specialists are often relatively small. LMG’s approach, systems and databases help create a portfolio of Best-of-Breed managers<br />The creation of a Fund-of-Fund based concept for this asset class makes sense business-wise.<br />However, most local players have only regional skills. An active asset allocation (AIM LMG) including Themes bloc is essential.<br />The ‘top-level’ Global best-of-breed managers will not disappear, but with their focus on large-cap they play a different game<br />If your size allows: use both approaches!<br />
  51. 51. Page 34<br />Contact/Questions<br />LMG Emerge <br />Zeist, The Netherlands<br />Erik L van Dijk, principal<br />Email:<br />Tel direct: +31 6 155 86 109<br />Tel office: +31 30 695 3828<br />Website:<br />FB Page:<br />Blog:<br />