Quantitative stock selection models work as well in emerging markets (EM) as they do in developed ones (DM). However, their implementation in the former requires additional expertise. Arlette van Ditshuizen and Tim Dröge from our quant equities team explain what makes quant investing in EM slightly more complex and how we address this challenge.
Tim Dröge: “Well, there are, in fact, many differences. Trading is different, regulation and corporate governance standards are different, capital gains taxes can be very different and currency conversion also needs to be handled differently. And that’s to name just a few examples.”
Arlette van Ditshuizen: “On the trading front, for example, there tends to be less liquidity in EM than in DM, while trading costs tend to be higher, which obviously has an impact on returns. But this is by no means the only difference. Another important aspect has to do with block trading. Unlike in the US or Japan, where there is almost no block trading, stocks in many EM countries are frequently traded in such significantly large numbers.”
“This is especially the case in countries such as Brazil, Mexico, Chile or Colombia, where large institutional investors like to trade blocks and therefore tend to be liquidity seekers. As investors, we like to provide that liquidity. This helps us bring down trading costs. For that purpose, Robeco has two EM trading desks – one in Hong Kong, for all Asian shares, and one in Boston, for shares from Latin American countries.”
We carry out additional screening in EM to ensure that the quality of the data used as input for our models is sufficient
Dröge: “Yes, governance is clearly an area in which EM-listed companies are not always on a par with their DM counterparts. Therefore, we carry out additional screening in EM to ensure that the quality of the data used as input for our models is sufficient and to identify any issues the model cannot detect. This is especially true for Chinese A-shares. Within Robeco’s quant equities team, portfolio manager Yaowei Xu is responsible for this extra step for two of our dedicated A-shares quantitative strategies: Active Quant Chinese A-shares, which is aimed at delivering stable outperformance, and Conservative China A-shares, which is aimed at delivering lower volatility.”
“These issues can range from simple ‘back-door listings’1 to potential fraud. For example, in recent years, a number of companies have seen their share prices plummet when informed market participants raised red flags after studying suspicious trading patterns and accounting reports.”
Dröge: “Yes, taxes are another very important issue. Broadly speaking, there are two main types of tax: exchange tax and capital gains tax. In India, for example, there is a 10% capital gains tax, while in South Africa they have a stamp duty. But you can avoid these by buying alternative instruments such as ADRs (American depository receipts) or GDRs (global depository receipts) instead of locally listed stocks.”
“What’s more, ADRs and GDRs offer many other advantages compared to locally listed stocks. Being listed in US dollars, in New York or London, they are generally easier to access and trade for foreign investors than locally listed stocks and don’t involve high currency conversion costs. They also usually involve lower custody and broker costs and are not subject to potential restrictions in terms of capital controls. All of these elements explain why for approximately 10% of our quant EM portfolios, we prefer to buy ADRs and GDRs instead of the local shares you’ll find in the index. In rare cases ADRs can also have disadvantages, like unclaimable dividend taxes or premiums. In such cases we aim to avoid the premium and buy the local shares instead.”
Van Ditshuizen: “Yes, but bear in mind that corporate actions such as mergers, spin-offs and delistings are generally more complicated to handle in EM anyway. The same goes for index additions and deletions, because a significant amount of money invested in EM is being managed relatively passively – either following index-based strategies or using a simple buy-and-hold approach. Compared to DM, the lack of arbitrageurs exacerbates the price moves triggered by addition and deletion announcements in EM.”
“To address this, Robeco’s teams follow a process that predicts whether a stock will be removed from the EM index. If that is the case, we aim to avoid buying it for our Conservative, Enhanced Index and Active Quant portfolios in the period between one month before the announcement date and the actual day of rebalancing. Additions to the MSCI EM Index are already included in the universe by including MSCI EM IMI small caps (and FTSE / S&P IFCI off-BM stocks) in the eligible universe. If these stocks are not yet in the MSCI EM Index, top-ranked companies can already be bought outside of the index and our strategies can therefore profit from MSCI additions. If countries are promoted from frontier to emerging market, we prefer to include the upgraded country as an off-benchmark opportunity six months before the effective date to benefit from expected upward market movements.”
Dröge: “Furthermore, with our Enhanced Indexing strategies, if a MSCI EM index deletion is ranked at the bottom according to our stock selection model, we aim to sell it before it is removed from the index.”
Dröge: “Currency conversion costs are indeed another difference. It is relatively straightforward to trade DM currencies like the euro, the US dollar and the British pound. These currencies are being traded efficiently by our FX trading desk. On the other hand, currencies like the Korean won, Indonesian rupiah, Brazilian real or Thai baht are not freely tradeable or may carry trading restrictions, so we need to outsource this to our custodian. To make sure conversion costs remain low, we have negotiated low spreads with our custodian and we ask them to net equity buy and sell transactions as much as possible, to minimize currency conversions.”
This article was initially published in our Quant Quarterly magazine.
1 A ‘back-door listing’ usually occurs when a privately held company purchases a publicly traded one, thereby avoiding the public offering process and securing an automatic stock exchange listing
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