Emerging Markets: Riding the Narrative

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Stockholm (HedgeNordic) – With emerging market countries enjoying higher-than-average economic growth amid the catching-up process with countries in the developed world, emerging markets can offer greater rates of return on investments. The downsides include erratic rates of economic growth and return, and more importantly, an occasionally broken relationship between economic growth and market returns.

“The major risk associated with investing in emerging markets is that you get this story-driven trading, that market participants, for whatever reason, decide there is a narrative influencing emerging markets,” Jonas Thulin (pictured), Head of Asset Management at Penser Bank, tells HedgeNordic. “The underlying macro fundamentals and corporate profitability are always overshadowed by a narrative or story that is believed to be negative for emerging markets,” he continues. “The biggest risk is this pricing trend that deviates sharply from the underlying fundamental developments.”

“The major risk associated with investing in emerging markets is that you get this story-driven trading, that market participants, for whatever reason, decide there is a narrative influencing emerging markets.”

“Emerging market assets are attractive for investors because they offer tremendous returns once market participants go for emerging markets,” Thulin tells HedgeNordic. “And vice versa, this group of countries is one of those regions where we are completely out when the market is not willing to buy into them,” he adds. “The decision to allocate to emerging markets, more than any other regions or asset classes, is always black and white for us, there is no gray area, either we are full steam ahead or we are completely out.”

“The decision to allocate to emerging markets, more than any other regions or asset classes, is always black and white for us, there is no gray area, either we are full steam ahead or we are completely out.”

With emerging markets accounting for about three-fourths of global economic growth on average, emerging market countries are set to gain a more relevant role in the global economic landscape. But one of the biggest risks faced by foreign investors seeking to invest in emerging markets remains the immature or volatile political systems. Inflation, the historically big challenge for emerging markets, is less of a concern at the moment. “There is a view that higher inflation and higher rates are distorting the performance of equity markets,” says Thulin, the Head of Asset Management at quant house Penser Bank. “Our statistical analysis shows that rates explain only ten percent of equity moves in emerging markets since September 1 and political risk explains 75 percent of the equity moves.”

“We like the fundamentals outlook for Brazil, for instance,” says Thulin, adding that “we own Brazilian equities because we believe the outlook is great.” The allocation to Brazil, however, “is an awful investment so far because politics always mess up things instead of letting the fundamentals flourish,” he continues. “We are not too concerned about inflation. We are more concerned about political risk when it comes to investing in emerging markets.”

In the Middle of the Bus

Barring any major political risk, waves of capital generally flow into emerging market assets when the economic cycle moves from recovery into expansion and risk aversion subsides. Because narratives tend to drive emerging market assets, Thulin and his team avoid being part of the first wave of investors coming into emerging markets when fundamentals point upwards. “Currently we have a very small allocation to emerging markets even though we like a lot of what we are seeing in terms of underlying macro fundamentals in emerging markets. We should come to a larger allocation to emerging markets,” says Thulin.

“Currently we have a very small allocation to emerging markets even though we like a lot of what we are seeing in terms of underlying macro fundamentals in emerging markets.”

“What speaks against this allocation decision is we do not want to be first movers into emerging markets,” Thulin tells HedgeNordic. “We would like to see a large portion of the market starting to buy into emerging markets and that is what we are waiting for. We are happy to be in the middle of the bus, we do not want to be at the very front or behind,” he continues. “But I definitely see there is a buying willingness in the market that can lift emerging markets. We think that should happen given the underlying fundamentals. But we are not there yet.”

Allocation Approach

“We are a data and a quant house. Using pretty much all macro data that is available in the world, we are running about 28,000 different time series through 16,000 different models on a weekly basis to find out what our exposure should look like,” Thulin explains his team’s approach to investing. “When we have the macro analysis done, we turn to the markets and ask ourselves what are the best products out there that can outperform on a relative basis given our macro analysis,” he continues. “We invest in emerging markets when and if we feel that emerging markets can compete on a global scale against all other asset classes and investments that are out there.”

“We invest in emerging markets when and if we feel that emerging markets can compete on a global scale against all other asset classes and investments that are out there.”

The asset management arm of Penser Bank is increasingly opting to get exposure to emerging markets via exchange-traded funds (ETFs). “ETFs are typically the most efficient way for us to execute thematic views. They are cheap and give a clean exposure offering good liquidity,” Thulin explains. Although ETFs are one of the best ways to get exposure to emerging markets, investors should pay close attention to the portfolio composition of these products. Many emerging markets ETFs may offer heavy exposure to legacy companies that are not run as efficiently as private companies or to state-owned banks, oil companies, among others.

“As per all the investments, you have to do your due diligence and make sure that the actual ETF is holding what you like it to hold,” emphasizes Thulin. “There are so many ETFs out there that the argument about emerging markets ETFs having heavy exposure to bad companies is certainly not applicable on the entire industry,” he continues. “There are bad apples in ETF baskets, but there are tons of them in the active fund management, too. For us, that is a strategic call, do we want to have state-owned enterprises or not. That is just part of the analysis.”

“There are bad apples in ETF baskets, but there are tons of them in the active fund management, too.”

Penser Bank has also made a strategic call to avoid energy-driven economies from emerging markets. “There has been a rally in emerging markets with the large energy exports, like Indonesia or Malaysia. We have decided not to put that in the basket because we do not want to trade too much on the rising oil price given that we want to keep away from fossil fuels and be sustainable in that sense,” says Thulin. “But we definitely see that we are giving up some value for the portfolio.” When it comes to finding yield in fixed-income markets, “we have to go on the edge or even further into frontier markets to find yield.”

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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