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By David Stevenson –
In this column I’d like to introduce what I rather inelegantly call the “linear link challenge”. In the real world of investing, pure ideas and strategies end up becoming horribly messy – we see a trend or a process at work and we try and find some way of ‘playing’ that via share or a fund.
Cue the linear challenge. Is there actually a direct link between that process or change (i.e. investment theme) and an actual, easy-to-buy fund or basket of shares? If there isn’t (and that can be the case in noisy, messy markets) we’re forced to rely on indirect ‘surrogates’ to make our play.
The good news with this challenge is that with most big trends you can fairly easily find yourself a basket of shares or a fund to play that process or change. But sometimes we can’t quite find a clean ‘play’ – a direct linear link between a fund and a theme – and we’re forced to use a lesser alternative.
In essence, my linear link challenge, especially as applied to ETFs, reminds us that funds in all their glorious shapes and sizes are exactly that – pooled, collective vehicles that capture a segment or market in a broad, diversified sense. These funds are rarely targeted on a particular theme and when they are, we’re usually more than a little disappointed. Too many clean energy funds (active or passive), for instance, are forced to diversify their holdings across a number of themes and segments, forcing the picky investor to say buy into nuclear when they really only wanted solar stocks!
Overall, I can’t say I’ve been that impressed with most of these ‘themed’ funds, and I’m obviously not alone. The low AUMs of many of these funds reminds us why broad, market access funds are so popular. Crucially, many of these themed funds also boast high expense ratios. So, by and large, we make do with broad ETFs, usually based around either a sector or a theme. Often we can find some clever work around, but every once in a while we run into a brick wall, forcing us to settle for the next best thing.
Three broad processes interest me right now, but the good news is that in each case there’s a fairly decent ETF that can be used to ‘access’ or ‘play’ the trend.
My three trends:
1) The relative success of frontier markets versus emerging markets
2) The need to focus on the right Asian countries in any Chinese recovery
3) The UK domestic consumer recovery
The first theme is arguably the most difficult, but the stats are absolutely fascinating. The work of UK based, liquidity-obsessed, CrossBorder Capital is crucial to the argument, as they’ve identified a massive disparity at the global liquidity level between frontier markets (FM) and traditional emerging markets (EM), with a resulting divergence in local equity returns. According to CrossBorder, over the period from beginning of 2013 to end of September, the MSCI Frontier Index was up 13.5% in US dollar terms whilst the MSCI Emerging Markets Index was down 4.23%. Yet as the researchers dug deeper they discovered a fascinating picture, with a sizeable liquidity gap developing between frontier and emerging markets, with emerging markets such as China suffering from weak liquidity whilst frontier markets benefited from a “strong liquidity backdrop”.
The key dynamic appears to be what’s called private sector liquidity (retained earnings, household savings and new credit) where correlation with emerging market capital flows since mid 2011 has been a negative -0.156. According to the research, emerging markets private sector liquidity is overwhelmingly determined by China and is negatively impacted by trends in US liquidity. With frontier markets it’s the exact opposite!
The experts at CrossBorder observe that “US Private Sector liquidity has been buoyant, but Chinese Private Sector Liquidity has skidded lower. … EM correlate closely with the Chinese business cycle, whereas FM appear to correlate more closely with the US business cycle”.
I think this analysis is hugely important as it reminds us that frontier markets are not necessarily just the more illiquid cousins to their bigger EM siblings – these diverse frontier markets (FM) boast their own unique drivers and correlations.
The problem for ETF investors is how to play this theme? How do we invest in frontier markets using lower cost tracker funds? The bad news is that I don’t quite trust the broad, global FM indices. I personally find them a bit flaky and liable to be disrupted by whatever country within the frontier is flavour of the moment. However, for the more adventurous amongst the ETF Strategy readership, I think there are some very interesting funds around, especially if one venture into the US space.
New York-based Global X Funds, in particular, has focused on building an extensive range of frontier ETF trackers, with two standing out: the Global X Nigeria Index ETF (NGE) and the Global X FTSE Andean 40 ETF (AND). Both boast net expense ratios around the 0.70% mark, are denominated in the default frontier currency (the dollar) and both have very clear linear linkages back to my FM vs EM story – if frontiers continue to do well, I’d reasonably expect places like Nigeria and Peru to do even better than the average.
The next key theme is that I also think that this dispersion of returns from FM versus EM will begin to fade away as key emerging markets begin to slowly rouse themselves from their current slumber. In particular, China should start to stir fairly soon, especially after the up and coming plenary session of the CCP. I’ve already bored ETF Strategy readers rigid with my brazen China bullishness but I accept that any pick-up in Chinese local equities will be a patchy and volatile affair. Crucially many foreign investors will continue to sit out any bounce, as they are (perhaps rightly) worried by local corporate governance and the influence of the Party and the State (as if there is any difference) on big business.
At this point I’d turn to the Asean countries as the best play on this slow but steady recovery. Many of these countries (Singapore, Malaysia, Thailand, Indonesia and the Philippines) are increasingly direct plays on Chinese recovery but captured through local markets where governance is much improved. But how to play this Asia ex China and Japan story in a simple, direct and low cost manner? Again Global X comes to the rescue with….you guessed it…the Global X FTSE ASEAN 40 ETF (ASEA). With expenses of 0.65% it’s a nice and clean way of playing the potential for recovery amongst the big companies playing in the Greater China story.
My last theme is more home grown and is focused on the nascent UK consumer recovery. I’d be erring on the side of optimism as we gaze out over the UK economy and I reckon we shouldn’t underestimate the big positive trends at work in our economy – it’s amazing what a spot of low interest rates can produce! In particular I’ve slowly turned into a housing optimist at long last and if you want to read a particularly bullish account of the UK housing market, then hunt down my recent Investment Week column! UK consumers are, in my humble opinion, slowly recovering their nerve and, as long as the austerity diehards can be kept away from the macro-economic levers, we should be in for a strong 2014.
The £64 million question then becomes how to ‘play’ the UK recovery. Just twelve months ago, the best tactic would have been to invest in a small assortment of UK house builders, followed by travel companies. Flash forward 12 months and that recovery is already in the share price of the many of these companies.
So, what can we do now? The consensus view would be to use a FTSE 250 tracker, of which there are many excellent low cost choices, but we can’t quite escape the impact of the global economy on the mid-cap big energy and miners nor internationally diversified industrials. At this point I find myself returning to another fund which is familiar to ETF Strategy readers, the London-listed First Trust United Kingdom AlphaDEX ETF (FKU). I won’t repeat the debate around smart beta, but simply observe that this ETF (TER of 0.80%) aims to filter through a FTSE 350 universe to find those stocks that might generate “positive alpha” relative to traditional passive indices. Crucially, it’s much more focused, with just 74 holdings, although these are fairly diversified within the index itself (i.e. low portfolio concentration). What we end up with in actual portfolio holdings is a fairly powerful group of very UK-focused companies.
I calculate that UK-focused sectors (consumer, financials, and health care) account for just under 60% of the fund’s total holdings. That’s not the 100% I’d be looking for – and not massively far away from a more traditional FTSE 250 tracker – but it’s the best linear link I can see, with a strong “growth meets value” set of quantitative screening criteria sitting under the bonnet. Obviously, if anyone out there could devise a pure-play UK sensitivity index (with 100% of the stocks focused largely on UK sales) with an associated ETF then I’d go for that….but sadly it doesn’t exist (yet)!
(The views and opinions expressed herein are the views and opinions of the author, David Stevenson, and do not necessarily reflect those of ETF Strategy.)