Beating The Emerging Markets Benchmark Blues by Morgan Harting, AllianceBernstein

It’s been another tough start to the year for emerging-market equities, amid growing concern about political risk and economic growth. But we believe the seeds have been sown for a recovery that can best be captured through a selective investing approach to avoid the risks of a benchmark.

Emerging-market equities have struggled so far this year. The MSCI Emerging Markets Index slipped by 0.6% through March 12 in US-dollar terms, after two consecutive years of declines. For the past five years through 2014, emerging-market equities have underperformed their developed-market peers by a wide margin, leaving valuations very low (Display).

Emerging Markets Benchmark Blues

Reasons to Rethink Developing Stocks

Should investors just stay away? Not so fast. There are still plenty of good reasons for investors to have an allocation to emerging equities today. For example, the strong US dollar and low oil prices are likely to fuel earnings profitability. Weakness in several key emerging currencies—including the Brazilian real, South African rand and Turkish lira—make many emerging companies look more competitive. And China is the world’s largest net importer of petroleum and other liquid fuels, so cheaper oil will be a godsend for its burdened economy. Many other developing countries, including India and South Korea, are also net oil importers and will benefit from lower energy costs too.

Global liquidity could also help. Money being pumped into markets by the European Central Bank and Bank of Japan could help mitigate the impact of a potential Fed rate hike on emerging-market stocks.

So what could be a catalyst for rerating cheap emerging-market stocks? In our view, a pickup in Europe combined with a sustained US recovery could lead to a revival in emerging-market demand—and an earnings recovery from very low consensus estimates (currently at 4% for 2015). In this environment, we think investors who identify companies with specific advantages are likely to be rewarded. Examples include IT firms in India, textile manufacturers in China and Taiwan, and Mexican food groups that export to the US, all of which should benefit from the favorable currency conditions today.

What’s Wrong with the Benchmark?

But even in an earnings recovery, we don’t expect a return to double-digit market growth. Many things have changed in recent years that make a repeat of the explosive equity gains in emerging markets unlikely. As a result, we think that buying the benchmark isn’t the right way to go.

In fact, the emerging-market index doesn’t have a great track record versus active managers. Last year, the MSCI Emerging Markets benchmark ranked in the 69th percentile of active managers. It hasn’t done much better for most of the past decade. In other words, a median-performing emerging-markets manager would have consistently beaten the benchmark over the past 10 years (Display).

Emerging Markets Benchmark Blues

Today, benchmarks are likely to be especially vulnerable, in our view. Political risk is rising in Russia, Brazil and Turkey, while China is facing a deceleration of economic growth. Passive exposure to emerging markets will force investors to take big positions in regions facing significant headwinds.

Active management offers distinct benefits. Emerging markets are still much more inefficient than developed markets, so there’s fertile ground for finding stock-specific opportunities that can deliver better performance than the market.

By staying active, the messiest parts of emerging markets can be avoided. And by taking a selective approach focused on developing high conviction in individual stocks, balanced by risk management, we believe investors can prepare for a potential recovery and beat the emerging benchmark blues.

This blog was originally published in InstitutionalInvestor.com

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Morgan Harting is a Portfolio Manager in emerging markets, and Sammy Suzuki is Portfolio Manager of Emerging Markets Strategic Core Equities, both at AllianceBernstein.