How to gear up emerging markets… without gearing

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We all know that small caps have an advantage over large caps over long periods and in most markets. We also know that emerging markets represent better long-term growth prospects in both economies and their markets.

But, what most super funds have not yet done is put the two together. This is a way to gear emerging markets, without gearing, as it were. And the results can be surprisingly less volatile than you’d expect.

Some have cottoned on already. According to Josh Moss, a managing director and portfolio manager of California-based EAM Investors, which is an affiliated manager of Australia’s Pacific Current Group, IOOF and one other Australian fund have committed to the discrete asset class.

Two of the traditional issues investors have had with both emerging markets and small caps as asset classes are liquidity and volatility. A recent paper by EAM, entitled ‘Emerging Markets Small Cap – An Undeserved Asset Class’ addresses both of these.

Even though it fits their remit, the EAM view is that combining small, or even microcap, securities with emerging markets, is definitely an active manager role. It is difficult to dispute that.

Moss said last week that a lot of the fund manager role in both emerging markets and small-cap stocks is to do with technology. There are about 6,000 securities in the emerging small-cap universe (market cap between US$100 million and US$3 billion), but Moss said that the number of investment strategies dedicated to this space was limited. There is another opportunity.

He said, in Sydney last week, that liquidity was important but, also, investors could use it as a “weapon”. EAM had its own trading desk, to maintain control over implementation, and invested only in stocks which had more than US$2 million a day in trades.

EAM has been visiting Australia since 2015. Australia, Moss said, was “ahead of the curve” in understanding the alpha-generation effect of blending emerging markets with small and microcaps.

Recent market performance, largely due to the “Trump effect”, which boosted the US dollar versus all currencies, has not favoured small caps or emerging markets. But the “Trump effect” is starting to fade. Order, via the markets, is being restored.

Moss said that 90 per cent of his firm’s performance attribution comes from stock selection. He is not so concerned about the macro twists and turns. Nevertheless, one suspects, the strategy is likely to take on a mean-reversion lift pretty soon.

– Greg Bright

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