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Does Style Matter in Emerging Markets?

The emerging market equity universe has become bigger, broader, and deeper. Over the last five years, clear style distinctions among investment managers have emerged. These style groups have generated differentiated patterns of performance—patterns that, in some cases, are negatively correlated.

In our view, this differentiation presents an opportunity to smooth portfolio volatility, achieve higher risk-adjusted returns, blend style exposures, and better determine asset class entry and exit points.

Developed market equity manager style distinctions have been measurable and comparable since at least the late 1980s, in the form of indices and style peer groups. Styles have evolved over the last 20 years, from top-down and bottom-up classifications to ones focused on growth, value, and core styles.

The advantages of style diversification within developed market equities have long been tested and implemented with success. The following analysis suggests that investors can now also exploit the benefits of style diversification across emerging market equities by structuring portfolios along style lines.

The Evolution of the Emerging Markets Equity Universe

As has occurred with other major asset classes, the structural changes, and resulting expansion of the number of investable countries, has broadened the emerging markets opportunity set.

Exhibit 1 shows the expansion in capitalisation of the broad MSCI indices. As it demonstrates, the market cap of the MSCI Emerging Markets Index has grown 300% over the last five years, outpacing all other broad indices.

Exhibit 1
Increase in Market Cap of the Emerging Markets Equity Universe

As of 31 March 2010
Source: MSCI

Clear style distinctions among investment managers have developed in the last five yearsTo answer the question, “Does style matter in emerging markets?”, we examined the emerging market equity manager universe, grouping managers into five groups (Deep Value, Relative Value, Core, Growth-at-a-Reasonable-Price (GARP) and Growth), based on z-scores (which measure a portfolio’s growth/value characteristics using other quantitative measures) , portfolio holdings, and manager-professed style. We further examined portfolio characteristics, tracking error and style-based regression to establish style-group “pureness.”

Our goal was to determine whether the five style buckets were discrete, and if emerging market equity styles had evolved. Exhibit 2 plots these five style groups on a holdings-based matrix  for the five-year period ending 31 December 2009.

The graph demonstrates that there are now five unique and non-overlapping emerging market equity styles.

Exhibit 2
The Five Emerging Market Style Groups

As of 31 December 2009
Source: Lazard

Exhibit 3 shows what this chart looked like five years ago—i.e., the same style groups mapped for the five-year period ending December 31, 2004. At that time, manager styles were more blurred.

Exhibit 3
At the End of 2004, Emerging Market Styles Were Just Beginning Their Evolution

As of 31 December 2004
Source: Lazard

Another way to evaluate style exposure is to use a value/growth z-score framework. Negative scores indicate value bias and positive scores indicate growth bias. Based on this methodology, Exhibit 4 also confirms the existence of five differentiated emerging market equity style groups.

The data also shows that style differentials have become more pronounced over time—the 2005 differential between Growth and Value managers ranged from -0.30 to +0.30. In 2008, it had widened to a range of -0.75 to 0.60.

Exhibit 4
The Five Style Groups Are Discrete and Non-Overlapping Through Time 

As of 31 December 2009
Source: Lazard

Style Groups Have Generated Differentiated—in Some Cases Negatively Correlated—Patterns of Performance

Manager performance (as tracked by the Deep Value and Growth style groups) reveals a pattern that is differentiated, and was negatively correlated during 2005, 2007 and 2009, as illustrated in Exhibit 5.

Exhibit 5
Deep Value and Growth Manager Performance Is Divergent 

As of 31 December 2009
Source: Lazard

Return differences can be sizeable. For the three-year period ending December 1999, for example, Growth managers dramatically outperformed Deep Value managers by almost 700 basis points, annualised.

Return dispersion can also be dramatic over short periods of time—over the 12 months ending December 2008, Deep Value managers outpaced Growth managers by 1,250 basis points.

We also compared capitalisation levels of Deep Value and Growth managers. Deep Value managers historically have had lower market capitalisation (average and median) relative to Growth managers (see Exhibit 6).

The difference in market cap can be explained by valuations. As market cap is a function of profitability and the multiple that an investor will pay, companies that can grow their earnings faster command a higher multiple in anticipation of higher prospective earnings.

This is one of many examples we found that highlight “source of return” differences (e.g., capitalisation, country, industry), which contribute to differentiated patterns of performance over medium to long time periods.

Exhibit 6
Market Capitalisation Differentials Exist
 

As of 31 December 2009
Source: Lazard

The Emerging Market Asset Class Is Inefficient

Emerging market equity managers have historically generated alpha. The chart in Exhibit 7  plots the 15-year average excess return for the median manager in the Relative Value style group and shows how the median manager averaged more than 3% excess return. Similar results can be observed in all other style groups.

We can safely conclude that active management has added a healthy return premium over the benchmark regardless of style.

Exhibit 7
There Is an Active Manager Premium  

Reference: Historical Active Management Premiums by Asset Class and Style, Callan Associates, December 31, 2009

Where the Opportunity Lies
  
Exhibit 8 depicts the Information Ratio advantage of blending Relative Value and GARP managers. Notably, this “blended style” strategy ranks consistently in the top third of the broad emerging markets universe.

Exhibit 8
Blending Styles Results in Higher Risk-Adjusted Returns

As of 31 December 2009

Conclusion

The development of emerging markets as an asset class over the past ten years has provided managers the opportunity to exploit growing country, industry, and security investment trade-offs. This has allowed investors to benefit from specialised patterns of return and risk, according to their objectives.

Growth, Value, Core and sub-style cycles exist within emerging markets. Blending styles can now be considered at a portfolio structure level. We believe that diversifying emerging markets equity exposure by manager style will:

• Smooth portfolio volatility
• Offer potentially higher risk-adjusted returns relative to single manager mandates
• Blend style exposures
• Allow investors (or managers) to better determine asset class entry and exit points

Moving to a multi-manager structure may require close evaluation of sub-style patterns of performance in the context of manager selection (e.g., a Relative Value manager may better complement a GARP manager than a Core manager).

We expect that emerging market style distinctions will continue to evolve with the transformation of the asset class.

This commentary is being provided for informational purposes only. The information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date, unless otherwise specified, and are subject to change.

This is a financial promotion and not intended to be investment advice.

Issued and approved by Lazard Asset Management Limited, 50 Stratton Street, London W1J 8LL. Lazard Asset Management Limited is incorporated in England and Wales with registered number 525667. It is authorised and regulated by the Financial Services Authority.

© 2010 Lazard Asset Management LLC

Company Profile

With origins dating back to the 19th century, Lazard Asset Management has a discreet yet considerable reputation for outstanding investment management expertise. We manage approximately £72 billion of assets* around the world across a broad range of asset classes including UK and global equities and fixed income. We have considerable experience of working with UK pension fund clients, managing almost £8 billion on their behalf via a number of relationships, including more than £2 billion for local authority clients.

 *All assets data as at 31 December 2009