2018’s late equity selloff left many investors disappointed and tired of traditional index funds and passive investing. Attributing some “would be”, and “should have” arguments, and a bit of hindsight bias, some investors decided to abandon the staple $SPY, $DJI, and $QQQ index-tracking ETFs. However, taking matters into one’s own hands usually warrants table-flipping reactions from professional investors to academics as they say in unison “passive investing outperforms active investing returns”. Turning to fixed-income may be one solution, but bonds were only slightly better underachievers. Moreover, passive investors are right to remain disgruntled at what ultimately seemed as a large opportunity cost in 2018, but must look forward and reexamine their positions and strategies.
Without discounting the validity of passive returns, and the prowess of the U.S. stock market there are workarounds to facilitate passive returns that will differ from existing conventions, reshaping risk profiles, and entertaining contrarian ideas.
The Case for Emerging Markets
The pitch for emerging markets has suffered in recent times due to low risk-premiums, trade wars, and political tensions, but many contrarian and foreign investors are ready to argue their cases once more. 2019 has shown YTD performance across emerging markets outperforming the gold standard SP500. China, Colombia, Argentina, and Brazil – among others – have all outperformed the fabled best YTD, with many other country-specific equity ETFs not trailing far behind.
As risk-premiums continue to progress towards acceptable standards it is important to note the long-term growth prospectus’ that underdeveloped nations have. The dynamics of the normally tumultuous macroeconomic and geopolitical emerging markets challenges are changing (Baker McKenzie, A Changing World: New Trends in Emerging Market Infrastructure Finance). While stocks sunk under Dollar pressure, many countries with the help of multi-lateral development finance institutions (DFIs) have played out the waiting game to great effect; facilitating further solutions for equity financing, small-medium enterprises, and general business climates. Most importantly, infrastructure finance and international securities exchange commissions are more effective than ever before. Recent foreign direct investment by China into African infrastructure has also warranted the attention of other nations. The market is heavily discounted and primed for investment, and the US wants in on the action. Healthy competition on the African markets creates more opportunity for business, draws in more capital lending, and more infrastructure development that ultimately translates to emerging market returns. Furthermore, China has announced plans for 1 Trillion USD of outbound investments targeting infrastructure. However, investors don’t need a seat on the Johannesburg Stock Exchange to reap benefits, ETFs offer enough exposure to DFI targeted regions. Even so, exposure isn’t cheap, the VanEck Vectors Africa ETF ($AFK), at 84 BP, offers exposure to companies that attribute the majority of their earnings to the African continent, weighted heavily in South Africa, Morocco, Kenya, and Nigeria – Africa’s now largest economy. Alternatively, should one be interested in focusing solely on exposure in Nigeria; the 88 BP, index-based Global X MSCI Nigeria ETF ($NGE) offers exposure to 20 companies listed, incorporated and operating in Nigeria.
Infrastructure development across the African continent backed by FDI is a testament to how globalisation affects world financial markets. Access to information and communication infrastructure has made it easier for budding entrepreneurs to become informed, and recognised by financial institutions – sometimes warranting public equity financing and prompting an IPO. IPO’s have been a hot topic in 2019 with Uber, Lyft, Slack, Pintrest, Airbnb, and (still possibly) Aramco’s upcoming debuts, but the action has not be reserved solely to developed markets. Emerging market stock exchanges across the world are encouraging public equity financing through DFI backed IPO initiatives. For retail investors initial public offerings remain a tricky bridge to cross; on one hand getting in on the ground floor represents a huge advantage for an investor, but on the other hand one must ask themselves whether they are ready to invest purely on a red herring prospectus (didn’t turn out so well for Snap. Inc shareholders).
Investing directly in international initial public offerings offers the risk of traditional IPOs and of emerging markets. The lack of information may be frustrating much like the price-discovery process, currency and foreign exchange risk may pin a position, and it can be expensive or impossible depending on your broker. At the same time, many IPO ETFs offer exposure that may cater to an investors risk profile in conjunction with a diversified portfolio.
Renaissance International IPO ETF ($IPOS) offers investors exposure to a diversified portfolio of IPO securities weighing heavily in China, Japan, Brazil, and German equities. First Trust International Equity Opportunities ETF ($FPXI) also offers IPO exposure by tracking a market-cap weighted index of the 50 largest international IPOs over their first 1,000 trading days.
The Healthy Proxy
Finally, after balancing alternative investment strategies it is important to underline the importance of the U.S. stock market. For investors reluctant to revisit their abandoned 2018 $SPY positions the YTD performance may beckon a bit of FOMO under current market conditions. Many investment portfolios are balanced with the SP500 risk profile in mind, and abandoning the U.S. market entirely may be a poor choice for passive investors, but there is a healthy alternative. In the last couple of years cash heavy – ethics conscious institutional investors have been turning their focus to companies that meet the environmental, social, and corporate governance criteria (NYSE:ESG) that measures the ethical impact of a company. Corporate social responsibility has always been an important factor in companies, but with increasing fluidity of information transfer it has become imperative for investors. The highlight reel of stellar company performance is all too easily besmirched by lawsuits and scandals – an idiosyncratic risk that is mitigated through ESG screening. Some argue that meeting ESG criterion mandates can be cost inducing – thus affecting profitability (and outperformance), but the benefits weigh in heavily. Study by Axioma Inc. has shown that companies boasting higher ESG scores tend to outperform traditional benchmarks, and Boston Consulting Group has shown that the difference is really made in pharmaceutical, consumer discretionary, and energy sectors.
The Flexshares STOXX US ESG Impact Index Fund ETF ($ESG) has a high correlation to the SP500 due to high overlap of assets, but is weighted differently. Notably, on March 8th, 2019, DWS Group launched the Xtrackers MSCI USA ESG Leaders Equity ETF ($USSG), with an expense rate of 10 BP, and $846 M AUM – now the third largest ESG ETF. Across the broad world of ETFs ESG focused products make up 0.2% total world exchange traded funds.
For those investors fully committed to avoiding benchmark exposures the pursuit for ethically sound companies extends into emerging markets.
Xtrackers MSCI Emerging Markets ESG Leaders Equity ETF ($EMSG) offers a similar exposure as $USSG, but geared towards emerging market countries, with exemption of several sectors (alcohol, gambling, weapons, tobacco, etc.).
In a constantly shifting financial ecosystem it is up to investors to continually reevaluate their portfolio balancing strategies regardless if they are a passive or active investor. While at times it may be tempting to set one's broker on speed-dial, pull in closer to the terminal, and trade-in passive ideals in adopting a traders mentality, it's best to keep a cool head and reexamine how the investor must change with the market.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.