Factor Investing in Emerging Markets

Over the past fifty years, financial economists in academia have built mathematical models to explain how excess returns can be obtained by investors in “efficient” markets. The Capital Asset Pricing Model (CAPM), developed during the 1960s, was the first formal model that sought to explain asset prices as a function of risk and return. According to this simple model, the equity market as a whole has a systemic return which is the excess return over a risk-free asset (i.e Treasury Bills) that an investor needs to assume the greater risk of the stock market. Market risk is called BETA in the model, with the risk free asset having a BETA of zero, the  market a BETA of one and riskier assets a BETA above one. BETA itself is  measured in terms of the correlation of an asset to the market and how volatile it is relative to the market.

Though the CAPM model remains the pillar of modern finance, academics have punched many holes in its one-factor (BETA) structure. A generation of finance PHDs have come up with “anomalies” in CAPM, which are additional factors that explain excess returns in a persistent manner over time, sectors and geographies. Initially small-capitalization stocks and value stocks (low price-to-book-value or low price-to-earnings relative to the market) where identified as generating a return premium. Then momentum (the tendency of rising stocks to keep rising and falling stocks to keep falling) gained acceptance, followed by quality and profitability. In recent years, academics have gone wild identifying multitudes of new factors, but most of these seem redundant, and the focus by investors is on the initial five.

The excess return premiums over the risk-free rate which investors expect from these factors (based on historical empirical evidence) are the following (Source, Your Complete guide to Factor-based Investing, Berkin&Swedroe):

Not only do the factors provide excess return premiums (for example, smalls caps add 3.3% of excess return), they also show negative correlations to the market excess return (BETA). This means that by tilting a portfolio to a specific factor the investor can expect to have both higher returns or lower volatility.

Given that the validity of these factors assumes prevalence over geographies, an investor should expect to find them in emerging markets. What is the evidence?;

The most recent academic research –”Size, Value, and Momentum in Emerging Market Stock Returns: Integrated or Segmented Pricing?”(SSN) , by Matthias X. Hanauer, Martin Linhart ( February 2015), analyzed the July 1996 to June 2012 period and found strong  value and momentum effects. However, they identified only a weaker size effect, and that only in Asia.

Lazard Asset Management, a prominent value manager, studied a similar time period (December 1999 to September 2015) and reached essentially the same conclusion (LAM). Lazard found a large value premium, best exploited through low PE and high dividend stocks (not low price/book). Lazard also found lower but still high momentum and quality premiums. Interestingly, these styles are negatively correlated to value in EM: momentum and quality perform strongly in rising markets, while value is resilient in down markets. Therefore, combining these factors can provide diversification benefits.

The absence of a premium for small-cap stocks in emerging markets would be surprising as this factor is highly prevalent over time in both the U.S. and international markets. Dimensional Fund Advisors (DFA) Management, a quant manager with exceptional academic credentials, has had a small cap EM fund (DEMSX) since 1998 that has performed poorly compared to its emerging market product (DFETX), as shown below:

Source: Yahoo Finance

However, emerging markets small caps have had very good relative performance since 2010, as shown below with DFA’s funds. Given the lack of long-term data for emerging markets, it is certainly plausible that a small-cap premium will materialize over time.

 

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