Learning From China’s Development-A Case For Active Management Within Asia by David Dali, Matthews Asia
Please note that due to the (U.S.) Thanksgiving holiday, the next Weekly Asia Update will be published on December 3, 2015.
Much is debated about the necessity of active management when it comes to investment portfolios. Being active managers ourselves, we are clearly biased. That said, from time to time, it is a worthwhile exercise to evaluate the various vehicles that investors have at their disposal to access growth.
As Asia becomes a larger part of the MSCI Emerging Markets (EM) Equity Index it is natural for investors to ask whether or not this benchmark index represents the best way to access the growth of emerging economies. And if not, is there a better way? This is clearly a broad topic that can be addressed many ways but for the purposes of this piece, we would like to focus on Asia as the largest region within the EM benchmark, and furthermore, attempt to highlight lessons learned from China, and the implications for investing in the region.
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To start, first we must realize that the Asian region is truly diverse in terms of its level of development. The region contains advanced economies such as Singapore, Japan and Hong Kong. It has its emerging economies, including China, India, South Korea, Malaysia and Thailand. And, of course, there are its frontier economies, which include Pakistan, Bangladesh, Vietnam and Sri Lanka.
The diversity of the Asian region creates not only significant investment opportunities but also its share of complications. Because of the complexity of emerging markets, and Asia more specifically, investors often lean on index-like investments to gain exposure. While this is fully understandable, it may not be ideal. For example, China recently achieved an important milestone: the faster growing services and consumption portion of the economy now accounts for more than half of China’s GDP. Yet the slowing industrial, construction and export driven sectors combined with less efficient state-owned enterprises (SOEs) still occupy an outsized representation within the MSCI China Index, making passive investments in the country less than optimal, in our opinion.
The same can be argued for the broader Emerging Markets index and, specifically, its Asia component. To analyze the concept and to illustrate the importance of active management within Asia, we charted China’s economic development in terms of GDP per capita and attempted to map sector performance of the MSCI China Index during different stages of China’s economic development. We find this analysis interesting given that many other Asian countries may follow a similar growth path. Any insights we can gather regarding sector performance can help us become better investors.
What we found was interesting and, more importantly, can serve as a supplemental roadmap for investing in emerging and frontier Asia. As the chart below highlights, during China’s early stages of economic development, sectors focused on basic necessities like energy, consumer staples and utilities were strong relative performers. As China grew between US$1,000 to US$2,000 per capita GDP, the energy, materials and health care sectors performed well. Further along in development, financial services and consumer discretionary sectors were leaders and finally as we approach current levels of Chinese development (per capita GDP of close to US$8,000), telecommunications and information technology have been among the leaders in performance.
So why is this analysis relevant? Many investors seek exposure to emerging markets to capture growth and to diversify risk away from their developed market holdings. This makes sense. However, how you access that growth matters and the construction of many of passive vehicles may not give investors what they are looking for. For example, the largest three countries within the MSCI Frontier Markets Index, Kuwait, Nigeria and Argentina, constitute almost 50% of the country weights and according to the IMF, 45% of the countries represented within this same index are forecasted to grow at less than 3% per annum on average during the next five years. Within broader emerging markets, passive vehicles may provide exposure to the largest countries, sectors and securities in terms of market capitalization, but we would argue that understanding the path of economic development of countries and investing in quality companies which benefit from the long term drivers of that development may be a more appropriate way of capturing desired growth.
Client Portfolio Strategist
It is not possible to invest directly in an index.