| Emerging Markets Are a Compelling Asset Class |
From an opportunistic investment choice earlier in the decade, emerging market equities have evolved into a core allocation for investors worldwide. This shift reflects a recognition that EM companies account for a substantial and rapidly growing share of the global corporate profit pool. With these trends likely to continue, both in terms of fundamentals and investor demand, we believe clients should rethink their level of exposure to the asset class.
Over our secular horizon, emerging economies are likely to continue on a path of stronger trend growth relative to developed markets. Emerging economies look more robust than their developed market peers on many traditional macroeconomic metrics, including current account balances, degree of indebtedness, foreign currency reserves and fiscal balances. In addition, higher growth rates in emerging economies are contributing to a burgeoning wealth effect that supports an expansion of the emerging market middle class and which should lead to stronger and more durable domestic consumption trends. These fundamental factors should support continued strong top- and bottom-line growth among emerging market companies and thus, the compelling nature of the investment opportunity in EM equities.
Improving fundamentals, together with the increased demand they have attracted and their strong performance over the past decade has helped build an attractive case for emerging market equities. Yet, many global investors remain under-allocated to emerging markets. Similarly, local asset pools such as pension funds have grown significantly in recent years yet remain quite small relative to their developed world peers. Both international and domestic investors, therefore, are potentially important sources of future demand that support expectations for strong long-term equity returns. As both economic fundamentals and demand dynamics remain supportive of the asset class, investments to emerging markets equity, in general, and the PIMCO Emerging Markets Equity Strategy in particular, represent a compelling investment opportunity for clients. |
| Our Investment Philosophy and Approach |
We believe the key to success in emerging market equities lies in taking a holistic approach that combines a rigorous bottom-up driven stock selection process with a comprehensive top-down macroeconomic framework and sound risk mitigation techniques. We believe this approach can best serve investors if the opportunity set is not constrained to that of – and when the resultant portfolio does not closely resemble – the benchmark. We are also comfortable taking contrarian views and holding cash if insufficient opportunities present themselves.
Our approach to finding return asymmetries in the space rests on fundamental bottom-up research that we believe is critical to navigating the less efficient and less transparent nature of the emerging equity markets. We focus on pricing of normalized earnings in an effort to identify situations in which the market is not recognizing the current and future earnings power of a company based upon reasonable assumptions of long-term performance. Overall, we believe investing with a long-term horizon on this basis can yield attractive risk-adjusted returns.
Still, in emerging markets, country- or currency-specific factors can often overwhelm more idiosyncratic factors as drivers of returns. To be successful in EM equities, therefore, it is essential that the investment process fully incorporate top-down considerations. In particular, expectations regarding growth and inflation over both cyclical and secular time frames are key not only to assessing the country and currency factors that tend to have a pronounced impact on emerging market equity returns, but also to refining views on the path of earnings and intrinsic value for individual companies. Further, top-down assessments are critically important in correctly judging risk-return asymmetries in emerging market shares given the linkages between emerging debt, equity and currency markets.
As mentioned, we also firmly believe in the importance of proactive risk management in a sector where downside risk can be quite significant. A portfolio that incorporates tail-risk hedging strategies to help minimize the impact of systemic shocks on overall portfolio performance may be positioned to provide better risk-adjusted returns over the full market cycle. Tail-risk hedging strategies refer to hedging against unknown financial crisis events. These crises are often referred to as “tail-risk events” because of the way they appear on the bell-shaped curve often used to illustrate market outcomes: The most likely outcomes lie at the center of the curve, whereas the unforeseen lie at either end, or the “tail” of the curve. |
| A Disciplined Investment Process |
The PIMCO Emerging Markets Equity Strategy applies our investment philosophy and harnesses the broader PIMCO platform in the three primary elements of strategy implementation: security selection, portfolio construction and ongoing portfolio review. Detailed qualitative and quantitative risk management is applied at each step of the strategy implementation process.
The emerging markets equity universe is a vast one in which over 3,000 companies comprise a broader emerging markets equity opportunity. In addition, there are many companies in the developed equities universe that we consider and evaluate, which have a significant portion of earnings derived from operations in emerging markets. In the first step of our process, the experience and expertise of our team of seasoned industry analysts combine with the insights provided by the PIMCO platform – including macro, regional, country, currency and credit views – to provide the filtering framework that enables us to narrow this wide universe of companies down to a high-potential focus list.
As we evaluate the focus list, our industry experts perform detailed research in an effort to identify return asymmetries between where companies are currently priced by the market and where we estimate their intrinsic value to be. We favor companies that we view as attractively priced on normalized or mid-cycle earnings, where there is evidence of improving fundamentals or other potential for the market to recognize the company’s intrinsic value. Certain companies face cyclical headwinds but are poised to prosper in time.
Our research process relies on a proprietary valuation framework using both asset-based and earnings/cash flow-based valuation approaches. There are many inputs to this process, including a detailed analysis of company financials, discussions with company management, conversations with other industry participants and a full analysis of the capital structure. A key differentiator is the incorporation of PIMCO’s macro, sovereign and credit research views in the projections that underpin our valuation framework.
Following a rigorous and iterative investment debate, portfolios are constructed by Masha Gordon – the strategy’s lead portfolio manager – who works with industry specialists to make a final selection on what securities to include in the portfolios. Each security must stand on its own merits and the resulting portfolio is constructed in a way that orders by rank each investment idea according to the perceived upside relative to the perceived downside. An ongoing dialogue with company management, reviewing investment theses and adjusting financial models, and assessing position sizes in relation to conviction, is necessary and critical. Our typical range of holdings is expected to be 60 to 100, with the largest single position typically representing no more than 5% of the portfolio.
Importantly, PIMCO’s many years of investment experience managing emerging market fixed income and currency portfolios are leveraged at the portfolio construction phase, as we seek to align our top-down macroeconomic exposures according to the firm’s views on countries and currencies.
Further, PIMCO’s experience and size enhance our insights across the capital structure, improving our execution capabilities and providing access to key company executives and country officials. While emerging markets equity investing is not without risk, we also incorporate PIMCO’s tail-risk hedging expertise to construct a portfolio that explicitly seeks to curtail the impact of large drawdowns resulting from left tail events in emerging market equities.
Our sell discipline is straightforward and rigorous. We reduce or completely sell a position when it reaches the analyst’s price target, if there is a change in the investment thesis, if there is a high probability of a systemic event with collateral damage to the security, or if the team identifies opportunities that are more attractive in terms of reward/risk. |
| Holistic Risk Management |
At each step of our investment process, we apply a rigorous risk management framework. Risk exposures are evaluated at the single security, country, sector, industry and factor level, and are continuously tested for key movements in related risk exposures. While our strategy is certainly not quantitative in nature, we find that a risk factor analysis can be helpful in terms of evaluating aggregate risk exposures across the portfolio. We identify concentrated risk exposures and ensure consistency with our fundamental views. From that, we calibrate and iterate to achieve a well-diversified portfolio with an appropriate alignment of fundamental views and risk exposures. As we evaluate risk exposures, we simultaneously access the need for tactical use of security, currency and market-hedging strategies. Beyond this framework, our risk aware process includes ongoing fundamental research, a disciplined buy and sell strategy, and an emphasis on diversification.
We focus on active share to determine the degree of active management rather than targeting a certain level of tracking error. Active share is a measure of the percentage of stock holdings in a portfolio that differ from the benchmark. It is calculated by taking the sum of the absolute value of the differences of the weight of each holding in the portfolio versus the weight of each holding in the benchmark index and dividing by two. In turn, we are comfortable running a high active share portfolio which scours the wide universe of EM securities, expresses our best investment ideas in a logical rank-ordered fashion, and explicitly incorporates strategies designed to limit downside risk. |
| Applications for the Strategy |
| We believe the emerging markets equity asset class is compelling for many types of investors and can be employed as part of an investor’s core equity allocation. Prudently applied active management is critically important to navigating volatility and returns in a risk-controlled framework. For purposes of gaining exposure to emerging equity markets in a core, diversified manner, PIMCO has a unique and comprehensive solution. |
| Expert Portfolio Management Team |
The PIMCO Emerging Markets Strategy is led by Masha Gordon, an executive vice president, and experienced emerging markets portfolio manager who most recently oversaw emerging markets investing at Goldman Sachs Asset Management. Masha leads a team of seasoned stock pickers who cover every major industry in the emerging markets space across all regions.
Each team member has between 10 and 15+ years of investment experience, offering seasoned insight into a wide universe of companies over multiple market and business cycles. The investment philosophy and process is aligned with PIMCO’s standards of excellence, integrity, and investing discipline. The team will collaborate closely with PIMCO’s emerging markets fixed income and currency teams, which currently oversee nearly $200 billion in emerging markets fixed income and currency assets across the globe (as of December 31, 2010).
PIMCO was an early emerging markets investor and we remain one of the largest, offering expertise in virtually every type of instrument and country in the emerging markets universe. Transactional excellence and real-time market insight is orchestrated by a dedicated team of experienced equity traders located in New York, London and Asia such that our positions, opportunities and market dynamics are evaluated on a 24-hour basis.
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