Emerging markets series: Are passives shut out of Chinese innovation gains?

Scott Longley

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Recent analysis from UBS on the Asian tech boom pointed out that the Organisation of Economic Cooperation and Development (OECD) definition of innovation is the ability to take something and make it better.

Yet in stating as the UBS analysts do that the opportunity in China and north Asia is one for active managers over passive funds, the analysts arguably are ignoring the innovation inherent in the world of ETFs and underestimating its ability to take the passive model and, indeed, make it better.

As the UBS report points out, there has been an explosion of creativity and innovation in China in recent years, and in areas such as artificial intelligence (AI) and fintech, Chinese companies are among the world-class leaders.

Crucially, they suggest this innovation is still not in the price of Chinese equity valuations. Though valuing such nebulous concepts can be difficult, a simple measure such as comparing enterprise value to cumulative R&D spend - both current and projected - would suggest that there is more of a significant undervaluation of Korean and Japanese stocks rather than China.

However, they add that the data set used is likely distorted by the rapid increases in R&D spending and the likely growth ahead. They conclude that global equity investors are yet to be convinced that Asia is able to innovate, despite decade worth of evidence from Japan and the current boom across the region of R&D spending, patent filing and educational improvements.

Combined, they should "serve as a warning that underestimating Asia's innovation rise is a mistake," the analyst team suggest.

For passive investors, though, the rate of change poses other problems that - according to UBS - means they are likely to lose out on growth even if they are aware of the potential in Asia.

The issue comes down to the rate of change in the make-up of indices. Referring back to research conducted in February, UBS point out that the rapidly changing nature of the economies in Asia is also leading to much more rapid change in the composition of stock markets.

Looking at the data for Europe, the US and Asia ex-Japan, UBS show that the annual index turnover in terms of the number of companies in Asia is considerably higher than in the developed regions at nearly 19% compared to 12-13% for Europe and the US.

UBS says that the rapid change in the structure of the economies is the main cause, as newer economy sectors have seen a dramatic expansion in terms of additions to the index at the expense of sectors such as industrials and materials.

The suggestion is that this rapid change is a headache for passive managers as they are unable to access the growth of new companies coming into the indices. The UBS team estimate that there was about 120 basis points of annual alpha that passive managers would have missed out on over the past 10 years.

Fast on their feet

Yet for all the work put into the analysis, there are suggestions that UBS is under-selling the ability of ETFs to be just as nimble as they need to be to match the movements of an index.

Ursula Marchioni, head of portfolio analysis and solutions at BlackRock, points out it is true that emerging markets in general and emerging markets in Asia in particular exhibit very differentiated behaviours across companies, thus creating the opportunity for active managers to deliver alpha.

But she adds: "Equally, on the indexing side, significant innovation has occurred in recent years, which means more precise exposures can be captured beyond capital markets indices."

Index investing has evolved well beyond market capitalised indices, she adds, and as new index solutions emerge to capture specific countries in Asia, market cap segments and style factors, the choice for investors will continue to expand allowing for more precise exposures to be implemented.

Similar points are made by Howie Li, chief executive at Canvas, part of ETF Securities. When it comes to China, there are complexities that aren't faced in other markets around A-shares (which are still excluded from the MSCI index, at least for now) and the main emerging market bond index which also currently excludes Chinese-issued bonds.

Yet how an investor wishes to be exposed to growth is also important. "Growth can come from relatively riskier assets via investing in growth sectors, growing emerging economies as well as growing companies which are small or medium in size," says Li.

"Generally, there are ETFs to cover these but it is important to ensure that the growth element that investors are looking for is part of a well-constructed portfolio. Some smart beta ETFs now have a 'growth' factor incorporated into the index strategy."

At issue here, in reality, is the nature of innovation in ETFs. As their popularity grows, so does the likelihood that smart beta funds will develop that look at the fundamentals of emerging markets and individual emerging market territories and ensure they are constructed accordingly. As Li concludes, more smart beta ETFs for emerging markets are likely to be developed and "these will look to capture the potentially attractive returns of emerging market investing but minimise certain risks where possible."

Index investing is evolving well beyond market capitalised indices, says Marchioni: "As new index solutions emerge - to capture specific countries in Asia, specific market capitalisation segments, specific style factors - investor choice will continue to expand and allow for different views and more precise exposures to be implemented."

It also means the trend towards growing emerging market ETF assets under management will continue. "Looking at the past five years, we have seen annual AUM growth of five per cent for emerging market equity ETFs globally, and we are confident that will continue of the long run," she concludes.

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