Seeking Alpha
Long only, long/short equity, CFA, portfolio strategy
Profile| Send Message|
( followers)  

The emerging markets have always been the beta trade. U.S. markets go up and Emerging Markets rise even more. The inverse was also true but we knew that going in. These were developing markets that would sometimes falter. Inflation, policy mistakes, revolutions, dictators you name it were all risks investors were willing to take to be in the ultimate growth trade. Then along comes 2011 and the world turns upside down.

(click to enlarge) Source ReutersiShares MSCI (NYSEARCA:<a href='http://seekingalpha.com/symbol/eem' title='iShares MSCI Emerging Markets ETF'>EEM</a>)

The U.S. and emerging markets decoupled leaving investors scratching their head. Over the last few years there were a few moments (EEM) started to rally but when all was said and done, by the end of 2013 the divergence was screaming something was very wrong.

Many analysts and portfolio managers pointed to the Fed taper as the probable cause. The reduction in bond purchases under the Fed's quantitative easing mandate would hit emerging markets especially hard. However, the divergence between US and developing market stocks was really established in 2011. The last QE program was put in place in late 2012. No one was talking about a taper then.

Abenomics and a weakening yen were pointed to as a thorn in the side of emerging markets. A more likely culprit was also mentioned. China has clearly been trying to unwind some of the excesses in its financial system. The voracious appetite for commodities that drove oil, copper and other resources to highs ended with a thud. The falling commodity prices that followed put pressure on commodity export driven economies like Brazil.

Emerging markets are made up of individual countries each with their own economies and politics. I wrote Monday that Larry Kudlow said it best pointing out many of these developing countries have swung wildly to the left. "Brazil has become Argentina and Argentina has become Venezuela."

China isn't much better. When investors see the phrase accounting issues, no questions are asked. You hit the sell button. The problem became so bad the SEC has barred the Chinese units of the big four accounting firms from auditing U.S. traded companies.

The Holy Grail

Wall Street loves statistics and reversion to the mean as tools to determine entry points into a security or put on spread trades, i.e. long one security short another. Traders often look at these trades as some sort of Holy Grail. Throughout my career, I've watched hedge fund traders including myself use this analysis sometimes successfully but often with catastrophic results.

(click to enlarge) Source Reuters

With the emerging markets and iShares MSCI EM ETF underperforming the US for the last few years traders are chomping on the bit to get long. Hedge Funds are putting on spread trades going long and short SPDR S&P 500 (NYSEARCA:SPY). As you can see in the relative performance chart has underperformed by over 57% since 2011. The theory is this spread has to collapse. Trust me; this trade looked attractive at 30%. Is this the outer band of what's possible; maybe.

Déjà vu All Over Again

I bring all this up because it echoes another favorite spread trade hedge funds piled into not that long ago. From the 2006 to 2011 Gold was on a trajectory to the moon. The U.S. was printing money hand over fist so the yellow metal took off. However, it soon became evident that gold stocks were no longer going along for the ride. With the advent of Gold ETF's like (NYSEARCA:GLD) and valuations high for the miners, the underperformance made sense. However, eventually the performance spread between the two widened so far, it became a siren song attracting spread and relative value traders into its web.

(click to enlarge) Source Reuters

By the beginning of 2011 the SPDR Gold ETF had outperformed the Market Vectors Gold Miners ETF (NYSEARCA:GDX) by over 46%. Fast forward several months and the spread widens to 100%. If you weren't wiped out already, today you're probably filing for bankruptcy. The performance gap now sits at over 121%.

A trade based on statistical arbitrage alone, is risky at best. Just ask Nobel Laureates Myron Scholes and Robert Merton how that worked out for them in 1998. They ran a little firm called Long Term Capital. After turning down a low ball offer from Warren Buffet, Alan Greenspan and the Federal Reserve had to orchestrate a bail out by the largest investment banks. Someone once said that the market can stay irrational longer than you can stay liquid.

Passive vs. Active Management

In the last 5 years almost 75% of emerging market mutual funds were outperformed by their benchmarks. The one notable exception was in emerging market small caps where a large number of managers outperformed. Is the time ripe for a change? Let's find out.

Many looking to invest in Emerging markets choose passive investments like the iShares MSCI EM ETF. It's liquid, cost effective and a favorite of hedge funds and retail investors as a way to get in and out quickly.

In recent years the passive approach to emerging markets has produced substandard returns. Some of the best performing markets this year are barely represented in this index. Vietnam (NYSEARCA:VNM) & Market Vectors Gulf States Index (NYSEARCA:MES) are up strongly this year. Two of the biggest trouble makers, China and Brazil rank at the top representing over 29%. No wonder it's sucking wind.

Listen to an Emerging Markets Expert

Ruchir Sharma, head of emerging markets at Morgan Stanley and author of the book Breakout Nations, hit the nail on its head during his interview with Yahoo Finance host Lauren Lyster on The Daily Ticker. He points out the importance of active management and differentiation. Some countries like Turkey have political risk and others like Brazil are growing at only 1%. Mr. Sharma says; Thinking about the emerging markets as one homogeneous entity is a mistake. He goes on to say; This passive style is going to go out of favor. You need a much more active style now ...

Pick and choose your countries carefully. For most of you this means choosing active mutual fund managers. Start thinking like a Swat Team. Trade in your shotgun for a sniper rifle.

Source: Emerging Market Investors Need To Go Active