Navigating the Complexities of SOEs in Emerging Markets
March 25, 2021
Seafarer Capital Partners
A Tale of Two Indices – Discussion with Steph Gan
Andrew Foster: Hello, everyone. My name is Andrew Foster, and I am the chief investment officer of Seafarer Capital Partners. I'm here today with Steph Gan, a colleague of mine who is a senior analyst at Seafarer, and I've had the privilege of working with her for the past three years. Steph is with me today to discuss a series of papers that she has authored that are available on our website, seafarerfunds.com.
Andrew: The series is called A Tale of Two Indices, and the series is intended to examine some of the prevailing benchmark indices that track the emerging markets, to explore their objectives, to understand better how they're designed and constructed, and even start to explore some of the pros and cons of these indices in terms of what they really excel at as well as what their potential limitations might be. So, Steph, can you kick off with a little bit of a description of what these papers are about?
Steph Gan: Sure. What we were trying to do with these papers was address an evergreen question of what sort of filters are in place with the passive benchmarks and what that means for investors that use these products. In the first part of the paper, we go behind the scenes into the literature of the leading benchmark providers and look at what they're using for benchmark construction. In the second of the series, we compare the benchmarks' representation of the emerging markets with an unfiltered version, and making these comparisons helps us to see the ways in which benchmark inclusion factors can change investment exposures.
Andrew: So Steph, tell us a little bit more about these factors. What are they and how do they drive the construction of the index?
Steph: Definitely. So for a benchmark to be successful, it has to be accessible to a large number of people so there isn't a scale constraint. So what you see often for benchmark providers is that they're really interested in maximizing accessibility of their product at the market level and on the security level. They want companies that are large, have traded at large volumes in the past, and are available broadly to any sort of foreign owner that wants access.
Steph: I think one interesting point is that, while these metrics are objective and quantifiable, there is some inevitable subjectivity that goes into defining an index. I think one example is the definition of what is an emerging market. You'll see that even with the same market data at the same time, different benchmark providers have come to different conclusions on markets like South Korea, Poland, and Kuwait, for example.
Andrew: Great. So can you tell us a little bit more about what the implication is for the indices today and how they're composed and whether or not they offer meaningful tracking of the emerging market universe?
Steph: Certainly. So as you would expect, this sort of requirement for maximum accessibility leads to somewhat of a bias toward large capitalization stocks, and that's particularly pronounced in some of the EM benchmarks that we looked at. Interestingly, even though the large emerging market benchmarks have continually evolved to expand their coverage, relative to developed markets you still see that emerging market equities are largely underrepresented in the leading indices. One large benchmark that we're looking at roughly tracked, I think, 24% of the available capitalization. You see much higher numbers for the US and EU.
Andrew: Great. Given those kinds of constraints that the indices face when trying to offer coverage of the emerging markets, are there alternate ways for investors to define the emerging market investment opportunity?
Steph: Yes. Here, when we're doing the research, we just decided to take the most straightforward and direct approach we could think of, which was just pooling the market capitalization of all emerging market equities as of a certain date, December 31st, 2019, in our case, and weighting them strictly based on the market cap on that date. We call this larger, more comprehensive set of companies our positive index, which we could then use to make comparisons with the commercial indices.
Steph: Somewhat surprisingly, we found that the positive index was pretty different from the commercial indices along any of the dimensions we chose to analyze, including country comparisons, industry comparisons, and company size.
Steph: Now, I want to draw your attention to one of our charts on this slide, capitalization focus can determine sector exposure. An output of our research was a keen realization that industry and capitalization can't be treated separately. This is because we believe in certain industries, large cap companies naturally excel through a series of consolidations. In this bucket, I would put telecom companies, some IT and financials such as banks.
Steph: On the other hand, within healthcare, industrials and real estate, these sectors can see a mix of capitalizations all doing well in their own right. So the conclusion was with a large capitalization skewing index, you're going to see some of the over representations and under representations that match what we just talked about.
Andrew: Thank you, Steph. So what would you have investors and readers of these papers ultimately take away?
Steph: I think, first of all, we need to acknowledge that there is some degree of active decision-making when you're investing, whether or not you're using active or passive products. Even when you're using a passive benchmark, you are implicitly over-weighting certain sectors, countries and capitalization skews. So that's one.
Steph: I think a second broader question is whether or not we still need the most stringent definitions of foreigner accessibility. I think 15, 20 years ago when these definitions were first struck, the EM was very different from the way it is today with a much smaller capitalization, many more illiquid companies. Certainly we've come a long way since then. Investors may ask themselves, what sort of exposures are they giving up or under-weighting in order to have the biggest definition of accessibility.
Andrew: Thanks, Steph, and thanks everyone for joining us here today. For those of you interested in learning more about this topic, please visit our website, seafarerfunds.com, where you can find Steph's two papers under the section entitled A Tale of Two Indices. Also, take a look at our extensive library of video content and market commentary on other topics and stay tuned for future content. Thanks, everyone, for joining us and please do stay healthy and safe. We wish you the best. Take care.