The Big Theme
Ask any financial adviser to recommend an emerging markets fund and the same names will crop up time and again: Aberdeen, First State, Templeton and JPMorgan. The sector remains dominated by a few select fund groups that have benefited immensely from investors' growing interest in emerging markets. On average, these groups hold around $50bn (£31bn) in assets - Aberdeen holds around this much in its Asia franchise alone. Consequently, many funds have reached a point beyond which capacity issues could start affecting performance, with many being soft-closed. Meanwhile, the emerging markets veterans spearheading many of these emerging markets mandates are approaching retirement age. Time for a changing of the guard?
Why size matters in emerging markets
At the beginning of this year, First State soft-closed a number of its funds including First State Asia Pacific Sustainability, First State Indian Subcontinent, First State Global Emerging Markets Sustainability, First State Latin America and First State Greater China Growth. Aberdeen has similarly asked financial advisers not to recommend its Aberdeen Emerging Markets Fund (£3.2bn-plus in size) and its Global Emerging Markets Fund in a bid to halt the inflows into these massive funds and protect existing investors. Soft-closure is a means of dissuading investors from putting new money into a fund by making the initial charge compulsory (as opposed to hard-closure where the fund does not accept any new money).
"I don't think anyone predicted the popularity of these funds when they first started and, even if they had, I don't see what they could have done to enable funds to grow in size and still be open and flexible as they were in the early days. They reflect what's happened in these markets, growing with them and adapting as time has gone on," says Tim Cockerill, head of collectives research at Rowan Dartington.
Of course, with a strong long-term performance record and, crucially, the ability to deliver in falling markets, the large fund inflows into First State and Aberdeen's mandates have been deserved. "Investors like tried and trusted managers and this status comes with time (and performance) so newcomers have to prove themselves - for this reason the 'old guard' will be in place for some time yet," says Mr Cockerill. "They have, of course, become concerned about the size of their funds and soft-closing them has occurred in some cases - Baillie Gifford has been running a good emerging markets fund but soft-closed it probably at the point when it would have started to gather a lot of assets."
While asset managers by their very definition aim to rake in funds, too much money flowing into open-ended vehicles can result in major capacity problems: it makes it difficult for the fund manager to adopt a nimble investment approach and near impossible to invest in less liquid names. This is a particular concern in the emerging markets space, where liquidity can be a major issue and the investment universe is only so big. As a fund grows larger, the manager may be confined to investing only in the larger, more liquid companies. "In order to offer the same investment strategy to all investors, an asset manager with a very large emerging markets fund may find he or she is confined to an investable universe of as little as 50 stocks. Beyond that, it will only be possible to take small positions and with this comes liquidity risk - you need time to build positions and time to get out again," explains Slim Feriani, chief executive of Advance Emerging Capital.
For Mr Feriani and his boutique outfit, which only has around $1bn of assets under management, the fact that the heavyweights in the sector are reaching capacity is good news, as it means his company can increase its slice of the emerging markets pie, as he puts it. "The pie will only get bigger - this is a structural growth story - an irreversible trend that we will not see the end of soon."
Mr Feriani maintains a bias towards the boutique model, believing that "small is beautiful" because it is more easily managed and less complicated, but admits that he still wants to grow his business. That said, Advance Emerging Capital is hardly a newcomer. Viewed as a pioneer in the frontier markets space, the company has been around for 15 years and is growing steadily. But as a boutique manager Mr Feriani says the company will limit its capacity to investing around $3bn in emerging markets and $1bn in frontier markets.
Of course, the boutique asset management model is not without its critics - many believe these players do not have the resources that the big players do or the marketing capacity, and often fees for the investor are higher. Mr Cockerill says: "The leading groups in this sector have promoted their funds and a boutique is going to struggle to promote a fund to the same extent and for long periods of time. Boutiques also lack the resources on the ground of the larger groups and, although large-cap emerging market stocks are well covered, there are lots of sectors and stocks in these markets that require a local presence to discover them. Even those with resources find that things don't always work out as planned - as Anthony Bolton will attest."
Mr Feriani concedes that this is a point often raised. But he believes Advance's funds-of-funds investment strategy mitigates this risk by investing in best-of-breed locally-based fund managers. It has built up a strong network of 80 investment teams in 27 countries who are experts in their own region/country - this gives the company local information advantage. In selecting funds, Mr Feriani says there is a definitive bias or tilt towards boutique emerging markets' managers outfits. "These managers can invest in mid and small caps, a space not as researched and one the 'big boys' can't get into. This is where you find the valuation anomalies and inefficiencies that help deliver outperformance."
Beyond Advance Emerging Capital, other boutique managers making inroads in the emerging markets space include Renaissance Asset Management, spearheaded by Plamen Monovski. The company's London-listed Russia Infrastructure Fund is in the top decile of infrastructure funds globally for its performance. Another (very) new kid on the block is Skyline Capital Management, a London-based global long/short equity specialist with an emerging markets focus. Skyline is looking to deliver healthy returns with less emerging market volatility via its Ucits fund, which might help overcome one of the longer-term issues of the sector. The fund will target through-cycle returns of 10 per cent-plus.
The fund structure
Tied to the issue of funds under management and capacity constraints is the structure of the vehicle - which should be an equally important consideration when investing in emerging markets. "I believe that investment trusts are the best vehicle for investing in emerging markets," says Mr Feriani, as there is an absence of flows into or out of their underlying portfolios of investment trusts.
Glyn Williams, an independent fund analyst, agrees. "Investment trusts can benefit quite a bit here [in emerging markets], so there may be an opportunity for groups to consider this, as managers will not need to dump stocks whenever retail investors take fright, which tends to leave open-ended fund managers with just the less liquid stocks, whereas the closed-end managers have no real issues to contend with on this particular front."
The result is that investment trust managers can take a longer-term view than their open-ended counterparts throughout the market cycle, without being forced to sell holdings or invest large inflows as demand for their investment trust fluctuates - one of the reasons why Anthony Bolton and Fidelity opted for this structure when launching the Fidelity China Special Situations Fund.
"The problem with open-ended funds is the risk of the fund manager becoming a cash manager rather than a long-term investor," says Mr Feriani. "When the fund is enjoying massive inflows they need to invest this; and likewise can be forced to sell the crown jewels on the way down if the fund suffers redemptions."
The other reason why Mr Feriani prefers investing in closed-ended funds is the opportunity to exploit discount opportunities and so generate an extra level of alpha that helps offset the extra layer of fees a funds-of-funds strategy can add. "Trading the discount opportunities of closed-ended funds is a no-brainer," he says. "Opportunities can arise in volatile marketing conditions - this was the case in 2008 when markets were deeply discounted." This type of value can also be unlocked through corporate action - liquidation, mergers, tenders and/or management change. Depending on the discount opportunities, Advance funds will typically hold a mixture of open- and closed-ended funds.
Beyond the capacity issues and fund structure, there is another often overlooked risk with the 'old guard'. Many of the 'star' fund managers in the emerging market space - that is the likes of Hugh Young (Aberdeen), Angus Tulloch (First State) and Dr Mark Mobius (Franklin Templeton) are all approaching retirement age. Dr. Mobius is 75 years old while Mr Tulloch is in his 60s and Mr Young in his mid 50s. Of course, longevity means they could still be investing for some time and they are supported by competent co-managers and a strong investment process, which will no doubt continue if they leave the helm. But the unknown factor is how the market will react when one leaves. "There is definitely a key man risk issue. Investors like to have a name, someone that they can hold accountable, and if one of these star fund managers leaves there is likely to be some outflows, although the extent of this is hard to predict," says Mr Feriani.
There is clearly an opportunity for fund management groups to compete with the established players but, despite there being quite a lot of emerging market funds already (59 in the IMA sector, 14 in the AIC's emerging market sector and 15 in its Asia Pacific excluding Japan sector), the leaders haven't really been challenged. "Perhaps the others need to reassess their investment processes because they haven't been delivering the results investors want - the five-year figures tell a story," says Tim Cockerill. But capacity issues shouldn't be ignored, as Mr Williams comments: "I have huge respect for Hugh Young at Aberdeen and Angus Tulloch at First State, but they are running into capacity issues, which will need to be addressed. At the same time, I really rather think that really longer-term investors will do better out of Advance and Renaissance funds, as I think they are really digging into the big opportunities looking forward. Where it all comes together is when you get the forward-thinking fund manager running a fund that is light on capacity issues."
Notes: Share price total return on £100 as at 11 May 2012