Since the 1970s when quantitative analysis began to dominate investing financial academics have looked for the drivers of investment returns. Initially, the focus was on explaining stock market returns in excess of risk free Treasury Bills in terms of compensation for higher risk. Then it was found that this market risk premia could be decomposed into the value and size factors, as empirical evidence showed that cheap stocks and small capitalization stocks provided their own excess returns beyond the market premia. Over time, academics have come up with a multitude of additional factors, of which quality (high profitability and low capital requirements) and momentum (rising stocks continue to outperform) are the most important.
Over the past twenty years these investment factors have become staples of the investment industry sponsored by index providers and investment firms. One of the benefits of this proliferation of new products and data is that it provides significant explanatory evidence for market developments. Emerging markets are no exception to this, and we can explain much of recent market developments in terms of factors.
The chart below shows the evolution of the primary investment factors in emerging market stocks for the past ten years. The data is from Professor Kenneth French’s website (link ) of Dartmouth College. The factors are small caps (SMB), value (HML), profitability (RMW), momentum (MOM) and low capital intensity (CMA). We can see that the past decade has been entirely dominated by the momentum factor. This was particularly true from the Spring of 2017 through the summer of 2020 which was the period of the great tech boom in both the U.S. and China. In a world of low growth (emerging markets and most of the global economy were in a state of semi-depression during the past ten years) and exceptionally low interest rates, long-duration “growthy” assets experienced significant expansions in their price to earnings multiples. Value and small caps stocks, on the other hand, are highly sensitive to economic conditions and, consequently, languished over this period. Not surprisingly, over this period “growth” investors came to completely dominate performance and asset accumulation, while “value” funds had a horrible decade. Note that value has had a big comeback since November of 2020, a move that has left most EM portfolio managers poorly positioned and with poor performance. This is shown in more detail in the second chart.
Investment factors, like most things in finance and investing, go through cycles of strength and weakness, with mean reversion periodically bringing them back to long term trends. The graph below shows the Fama-French data for emerging markets from 1989 until June 2022. We can see that over this 32 year period, the momentum (MOM) and value (HML) factors have generated large premia while small caps (SMB), profitability (RMW) and low capital intensity (CMA) have provided more modest premia. Both momentum and value have had long periods of superior performance, and since 2014 momentum has taken off dramatically.
The following chart provides more detail with a decade by decade breakdown for MSCI EM from 1992-2022 and for the S&P500 from 1962 to 1992. We can see that in both the U.S. and EM factor performance is inconsistent, varying significantly from one decade to another. The fact that factors can lag for extended periods of time (a decade is an eternity in the life of a portfolio manager) means that these trends determine the trends of the investment industry. For example, the phenomenal success of Warren Buffett, considered the leading investor of the past forty years, was driven by the huge premia provided by the value factor between 1972 and 1992. If Buffett had launched his fund in 2002, he surely would have gone out of business very quickly.
In EM, though all factors under consideration provide premia, for small caps (SMB) almost all the outperformance was secured in the 1992-2002 decade, and for value (HML) most of the premia was accumulated during 1992-2012. The poor performance of small caps explains why this market segment is neglected in the EM fund industry. The very strong performance of EM value in the 1992-2012 period made this style of investing very popular with fund managers and fund marketers. However, the poor performance of value between 2012-2020 nearly decimated this style of investing and led to the closure of many funds. With EM value bouncing back over the past two years, catching almost all fund managers off guard, it will be interesting to see if value investing makes a comeback.