Home / How to use emerging markets for better diversification

(Pictured: James Norman)

QS Investors, the top-down global manager, has launched an Australian-domiciled emerging markets fund, as investors are taking a second look at the asset class following the recent correction. QS Investors, which already has about A$1 billion in Australasian-sourced investments, offers an alternative to fundamentals-driven stock selection in these markets. The firm concentrates on diversification reflected by low correlations.

James Norman, one of the founders of QS Investors, spent two weeks in Australia last month.  For him, there is currently an “excellent” opportunity in emerging markets. But the interesting thing is how his firm goes about realizing the opportunity.

QS Investors got its start as the small quant department within Deutsche Asset Management in New York in the 1990s. At the height of the tech boom, in 2000, one of its big pension fund clients expressed some nervousness about the way its portfolio had suddenly become skewed to tech stocks, doubling the strategic weighting in a short space of time. The team also observed that the fund’s bottom-up managers had an even greater overweight to tech stocks.

Norman, who had joined the firm in 1995, says that the pension fund had had a similar experience in the late 1980s, when it saw its global portfolio become skewed to Japan as that market roared, before spectacularly plummeting and subsequently staying down for a long period. Another issue in that environment is that the investor and its managers tend to overlook other opportunities which are occurring at the same time. They are too focused on the hot sector of the moment.

The upshot is that QS Investors has developed a strategy which identifies markets and sectors around the world which are behaving differently from others. In the emerging markets space, for instance, the BRICs have tended to act in a correlated manner until recently, when India has started to behave differently. QS Investors’ new fund is underweight China, Brazil and Russia and overweight India compared with the MSCI EM index. Other countries whose investment statistics are behaving “differently” at the moment include Chile and Turkey.

Norman says: “The large developing markets are acting more like the developed markets. The index (MSCI EM) has the biggest weightings to those countries which are most integrated with the West…

“When we look at emerging markets we identify those parts which are behaving differently,” he says. “We equal weight the capital for risks and we look at what are the opportunities.”

Among the major sectors, for instance, telecoms are currently behaving differently from the other industrials, presenting a diversification opportunity. Telecoms have the added advantage of usually providing stable earnings and dividends. Recent growth has been driven, in particular, by those with a cellular phone exposure.

As a top-down manager, QS Investors concentrates on exploiting the systematic diversification benefits provided by macro factors and investor behaviour. The firm actually weathered the 2007-2008 crisis quite well compared with bottom-up quant managers. It’s analysts start with a qualitative view on how markets or sectors are behaving and then crunch the numbers to decide how to realize the opportunities. The strategy has shown to maximise diversification benefits, namely mitigating concentration risk and downside risk

Norman says: “We found phenomenal opportunities in 2008 and we did well, relatively. We try to avoid the behavior of the stock-selections quants. We are investors who are driven by insights.”

QS Investors became a privately owned firm in 2010, having done a management buy-out from Deutsche. The firm is represented in Australia by Brookvine. Brookvine executive director, Stephen O’Brien, is the former managing director of Deutsche Asset Management in Australia, who joined the incubator and marketing firm this year. Brookvine is a co-investor in the new QS Investors Australian-domiciled emerging markets fund.

O’Brien said: “Given the uncertainties across the globe, most big investors are carefully considering their exposures. We think that they should have a look at how QS Investors approaches global equities, especially emerging markets, if they’re looking for genuine diversification in their portfolio.”