Milltrust International has close to half a billion US dollars invested in the emerging markets, and Eric Anderson Managing Partner at Milltrust International, Head of Emerging Market Investments and the Lead Portfolio Manager on all their Emerging Market strategies, explains that one third of this is used through the firm’s ETF strategy.
“We found that this low-cost, high-alpha strategy is appealing to more and more investors who are seeking a cost effective but differentiated way to gain exposure to the asset class,” Anderson says.
Anderson believes there are two ways to make money when managing investments in Emerging Markets equities.
“One, is by getting your stock selection right and, two, is by correctly managing your geographical exposure. If an investor is looking to maximise their returns in this asset class, they will need to exploit both of these sources of alpha,” Anderson says.
“However, as we saw in 2018, making the right country calls can sometimes significantly outweigh picking the right company. In fact, MSCI published a study showing that country factors have contributed around 40 per cent to 60 per cent of Emerging Markets stock-level dispersions since 1997. Industry and style (size, value, etc) represent the other factors.
Anderson comments that the importance of country factors comes as no surprise given the level of disparity within the Emerging Markets universe.
“If you were to broadly categorise the different countries, you could separate the EM universe into three categories: The commodity plays (which include Russia, Brazil); The exporters (Korea, Taiwan, …), and thirdly, the domestic-focused economies (China, India, …). All of these investment buckets represent such vastly different market drivers that differentiating between them when investing is a no-brainer. Our aim was to find a way to exploit this very obvious dynamic.”
Anderson outlines Milltrust’s strategy, commenting that corporate profitability, stock market performance, consumer behaviour, sentiment and capital expenditure are all affected by inflation, interest rates, economic growth amongst other important economic and fundamental factors.
“We regularly see TV pundits and experts make frequent investment assumptions, predicting stock market performance based on various indicators; ‘I think the central bank will lower interest rates, so the stock market will go up’.
“Over the last 10 years, we have tested these different investment assumptions that people make all the time to see if the relationship holds true and identified which of these factors really conveys information about future equity returns. It is these quantitative indicators that we use to evaluate the attractiveness of each equity market relative to each other in order to provide country allocation recommendations with the goal of enhancing the returns of unhedged global Emerging Market equity portfolios.
“As you would expect, our model includes a valuation component where we favour cheaper markets, a growth and profitability component and a momentum component amongst a number of other factors. This is a very disciplined and systematic process.”
Putting the strategy into practice where Milltrust can play its country tilts from its asset allocation models, the firm needed to find market instruments that were liquid enough and that provided a reasonable enough representation of the country’s stock market. The answer was discovered in using low-cost index-tracking country ETFs.
“Using passive ETFs to gain exposure to Emerging Markets has been popular amongst investors,” Anderson says. “Most investors tend to buy one of the ETFs that tracks the MSCI Emerging Markets Index. The inefficiencies of tracking such an index which is market-cap weighted is well publicised. There are times when you want to be overweight the commodity countries and other times when you want more exposure to the exporters, etc, regardless of market cap weights. Our approach is to use the more granular country ETFs to express our country views that come out of our country allocation model. We use about 20 different EM country ETFs.”
His finding was that there was ample liquidity in EM country ETFs. “If you look at the three-month average daily dollar trading volume (ADV) of the iShares EM country ETFs, the majority of them have an ADV of more than USD10 million per day which is more than sufficient to run our strategy effectively,” he says.
“In addition to the direct liquidity, we found that additional shares can also be created by brokers at low cost. For the smaller countries (such as Qater, UAE, Colombia), whose country ETFs are less liquid, we have applied some practical constraints; no matter how high their scores are, we set a maximum allocation versus the benchmark weight (for instance, benchmark weight plus 4 per cent).
“Since our country allocation models focus on medium to long-term trends, we only trade and rebalance the portfolio monthly which keeps our transaction costs down while still being frequent enough to capture market moves and shifts from our country views. Intra-month you can often find yourself getting caught up in too much noise as markets may have an immediate, very short-term reaction to certain events before reverting back to its fair value.”
In conclusion, Anderson explains that the firm has implemented this low-cost, high-alpha strategy as an advisory portfolio for its clients since 2012.
“The performance has averaged nearly 3 per cent annualised alpha over the MSCI EM Index which consists of the actual returns of the country ETFs; the performance is what would have been achieved by an investor who invested in accordance with our recommendations.”
