The opportunity in Asian equities for long-term investors
The spread of COVID-19 has taken its toll on equity markets globally, and whilst we have much to learn about the eventual underlying economic impact of the virus, there are reasons to remain invested and opportunities to take advantage of across Asian equity markets.
As the world economy sinks into recession due to the disruption caused by the COVID-19 pandemic, investors face the short-term challenge of how to think through a totally different kind of recession as well as the longer-term one of how this crisis will change our economies and markets.
In such an uncertain environment, having a long-term perspective takes on added importance, especially in markets that can be volatile, like Asian equities. However, periods of short-term volatility can provide an excellent opportunity for investors to establish or increase an allocation to the region. At any point since 1987, an investor in Asian equities with an investment horizon of 7 years or more has experienced a positive total return, highlighting the importance of looking through short-term market movements.
Figure 1: Historic probability of a positive total return in the MSCI AC Asia ex Japan (NR) Index since 1987
Why have Asian equities underperformed despite strong macroeconomic trends?
In a world searching for growth, structural and cyclical forces are combining to highlight the attractiveness of Asia as a destination for investment. China has been the undoubted star of the region given its sheer size and growth trajectory, while other parts of Asia have registered equally impressive gains. The International Monetary Fund (IMF) estimates that emerging and developing Asia is around one-third of global gross domestic product (GDP) today, making the region over twice the size of the United States. By 2023, it is estimated that the economies of emerging and developing Asia will be larger than all the advanced economies combined.
Of course, strong economic growth does not necessarily equate to better investment outcomes. The backlash against globalisation is having a material impact on global supply chains and business confidence throughout the region. However, we believe that secular growth trends within the Asian millennial generation indicates that the region will be an attractive source of investment returns for years to come. The region is simply too large to ignore for Australian investors.
Despite better growth outcomes, an investor looking at the relative performance of an Asian equity index versus that of developed nations would be disappointed. Developed market equity markets have outperformed their Asian equivalents since 2010. For this reason, investors have questioned how they should get exposure to Asia within their portfolios.
Figure 2: The long relative return cycle of developed versus Asia ex Japan equities, MSCI AC Asia ex Japan (NR) /MSCI World (NR)
The problems with passive investing in Asia
To understand the relative underperformance of Asia relative to developed markets, it is important to understand the composition of equity market indices that represent the region. The largest five companies account for over 26% of the index and are thus a large determinant of the market’s performance. By way of comparison, the top five company weights in the US S&P 500 and S&P/ASX 200 account for 20% and 30%, respectively.
Companies and sectors that are likely to benefit going forward in Asia (like health care, consumer discretionary and services) are under-represented in market cap weighted indices, which are dominated by commodity-based and industrial companies. The index is laden with state-owned enterprises and ‘old economy’ companies. Many of these companies aren’t managed well and aren’t exposed to tomorrow’s growth drivers. The MSCI Asia ex Japan index is also skewed to slower-growing nations like South Korea and Taiwan, which account for almost 28% of the index.
As Australian investors already know, the ASX 200 index doesn’t represent the full set of opportunities in the Australian equity market, and it is a similar story in Asia. The MSCI Index is restricted by liquidity requirements and it underrepresents companies that either trade less or are in the smaller market capitalisation range and emerging sectors, where structural growth is currently strongest.
In addition, indices that are constructed using the market capitalisation of companies in Asia tend to be backward- rather than forward-looking. This approach rewards those companies that have succeeded in the past, in the old export-driven and commodity-hungry economies, without accounting for the potential for future growth or risks.
By taking a forward-looking approach to allocating capital, active investment managers can gain exposure to those sectors that are most likely to benefit from the long-term structural developments spoken about earlier in this paper. As Asian economies continue to move up the economic development curve, their growth models will rotate from export-led development to consumption-led growth, providing opportunities for investors to gain exposure to companies likely to benefit from these trends. Those companies that were the winners yesterday will not necessarily be the winners of tomorrow.
For example, active investors have the flexibility to quickly shift their investment allocations and can rotate exposures to those sectors and companies with the best risk-adjusted return potential. For example, China’s health care industry is projected to be worth US$2.4 trillion by 2030.While health care in the US is the second-largest sector by market cap, it ranks only eighth in China, suggesting that the sector is still early in its development and will likely grow going forward.
Finally, Asian equity markets are less efficient than their developed counterparts. That means active managers like Fidelity International enjoy a greater opportunity to use in-depth research to uncover mispriced securities. For example, the average stock in the MSCI Asia ex Japan Index is covered by fewer sell-side analysts than in the developed markets, and many smaller stocks receive little or no analyst coverage. Divergent legal standards, accounting practices and languages across countries add to the complexity within the region, which is why having regionally-based investment analysts is vital to producing superior performance and, equally, avoiding losses.
When it comes to Asia – think active
Global equity indices do not reflect Asia’s current economic and future economic importance. For example, Asia ex Japan companies only account for around 10% of the MSCI All Country World Index. To gain exposure to the opportunity in the region, we believe that the best approach is to invest in locally domiciled companies – rather than foreign multi-national companies – that are best positioned to benefit from the long-term trends and changing consumer preferences in Asia.
Asian economies are expected to grow faster than those of Europe and North America in coming decades. Asian equity markets are also expected to grow even faster. This process of modernisation and rapid change is often captured late in benchmarks.
For investors, it’s important to understand the areas of Asia’s economy that will potentially benefit from this evolution. When thinking about companies that will benefit from rising wealth across the region, the Asia of the next decade tends to look very different from current benchmark sector weightings. Rather than focus on large banks, petrochemical and industrial companies, the Asia of the future should look more like the developed economies, with a focus on consumer goods, health, leisure, travel and technology. These assumptions lead to a very different allocation than that found in benchmarks.
In our opinion, if an investor develops a positive investment thesis, then the best way to enhance portfolio returns is to invest in the companies and sectors closest to the thesis. Investing in multi-national companies domiciled in the developed world will likely dilute portfolio returns relative to direct exposure. By investing directly in the region, an investor also has more control over their asset allocation, rather than trying to speculate or analyse how much exposure one may or may not have to a particular market.
Due to the current crisis, there is increasing bifurcation at a country, sector, and company level between the winners and losers of the next decade. Given the uncertainty surrounding the impact of COVID-19, it is vital that investors take an active approach to identify those companies that are most likely to survive and potentially thrive in the long-run.
At Fidelity, we believe it is possible to generate superior investment outcomes for our clients, based on a bedrock of fundamental company analysis, robust risk management framework and a highly active approach to stock selection. For this reason, we believe that direct Asian equity market exposure can play a substantial diversifying role in Australian investors’ investment portfolios.
The Fidelity Asia Fund – an active approach that can harvest the gains on offer in Asia
Fidelity has 50 years’ experience building investment teams in the Asia region and today we believe no one knows the area better. Fidelity has committed significant resources in the Asia Pacific ex Japan region to undertake more in-depth research. A network of 44 equity research professionals based throughout the region in Hong Kong, Mumbai, Shanghai, Singapore, Sydney and Taipei interpreting events and trends in their local markets gives Fidelity an important advantage over our competitors.
The Fidelity Asia Fund, managed by Anthony Srom since June 2014, follows an active bottom-up investment approach, capturing high conviction ideas from across the Asia Pacific ex Japan region. The concentrated portfolio of 20–35 stocks provides the potential for each holding to significantly contribute to overall fund performance.
By holding fewer names, we believe that we can spend more time delving deeper in to a potential investment and really understand the key drivers behind its future stock performance.
High conviction does not mean high risk and the Fund has exhibited lower volatility than the market and peers. The Fund will typically have an anchor of large-cap, stable companies with strong balance sheets and stable cash flows. This potentially will provide an element of downside protection during challenging market conditions.
Figure 3: Relative return, Fidelity Asia Fund and MSCI AC Asia ex Japan (NR) /MSCI World (NR)
To highlight the benefits of Fidelity’s active approach to investing in Asia, Figure 3 shows the relative return of the Fidelity Asia Fund and the MSCI Asia ex Japan Index (NR) versus the MSCI World (NR) Index (as shown previously in Figure 1). An investor who focused on the headline Asia ex Japan Index could assume that the structural, long-term macroeconomic themes in the Asian region are difficult to exploit and should retain their developed market exposure, given the stronger relative performance of developed market equities. Hence, a passive investor would have largely been disappointed in the performance of their investment relative to developed markets since 2010.
However, by taking an active approach and exploiting some of the long-run structural themes that exist within Asia, Anthony Srom has delivered returns that have outpaced the strong performance of the MSCI World (NR) under his tenure as Portfolio Manager of the Fidelity Asia Fund. Additionally, performance of the Fidelity Asia Fund has been excellent under Anthony’s tenure, generating substantial outperformance relative to the Fund’s comparative index and competitive peer group.
Figure 4: The best-performing Asian equities funds over portfolio manager’s tenure
The index is the MSCI AC Asia ex Japan (NR). NR: NR at the end of the benchmark name indicates the return is calculated including reinvesting net dividends. The dividend is reinvested after deduction of withholding tax, applying the withholding tax rate to non-resident individuals who do not benefit from double taxation treaties.
Fund manager tenure since 1 June 2014. Total net returns represent past performance only. Performance returns are shown net of fees in AUD terms. Past performance is not a reliable indicator of future performance. Returns of the Fund can be volatile and in some periods may be negative.
Asian equity markets don’t just offer Australian investors growth potential, they also increasingly offer genuine diversity and possible protection from an economic downturn in the developed world. Of course, proximity to these markets is important for the ability to assess the risk associated with investments there. It’s why we place so much emphasis on bottom-up, fundamental research. Our concentrated, high-conviction approach has resulted in the best-performing fund and delivered significant outperformance relative to the MSCI AC Asia ex Japan (NR) benchmark.
With governments rapidly expanding their budgets to support their countries, central banks once again embarking upon unconventional monetary policy, and yields on cash and defensive assets likely to be insufficient to generate a return above inflation for the foreseeable future, now is an opportune time for Australian investors to consider the potential benefits of a long-term allocation to Asian equities in their diversified portfolios.
 As at 30/4/2020
 As at 30/4/2020
 As at 30/4/2020.
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