Thursday, June 21, 2018

The good, the bad and the ugly: Three reasons U.S. rates are going up

By Eric Winograd, Guest Columnist

The U.S. Federal Reserve decided against an official short-term rate hike during a recent meeting—hardly a surprise. But U.S. Treasury yields continue to climb in 2018, and not all the explanations are good news.

Higher interest rates are arguably the most striking feature of the financial landscape this year. Major equity indices are virtually unchanged, and so is the U.S. dollar, but two-year U.S. Treasury yields are up by 60 basis points, and the 10-year Treasury is up by 50 basis points.

We see three main reasons why interest rates are rising in 2018:

  1. The Good: Economic Growth Is Strong. The U.S economy has been rolling—and the momentum is likely to continue. Through the end of the first quarter, gross domestic product (GDP) expanded by 2.9% year over year. That’s well above any reasonable estimate of potential growth (typically between 1.75% and 2.0%). Higher-frequency indicators suggest that growth will remain healthy. If rates rise because growth expectations are up, that’s a good thing—it means investors are confident in the economy.
  2. The Bad: Inflation Is Waking Up, Too. Inflation is rising along with growth. Right now, the price increases (around 2% by a variety of measures) aren’t alarming, but pressures have clearly picked up over the past few months. Rising commodity prices and robust labor markets suggest that there’s fuel for rates to rise further. When inflation was too low in the wake of the recession, rising inflation would have been welcomed. But with the business cycle much more advanced now, further inflation increases would be bad. They could force the Fed to overtighten, hurting economic growth. Or they could drive up expectations of future inflation, impairing plans for business investment.
  3. The Ugly: The Budget Balance Is Deteriorating. Growth and inflation can tell us a lot about the demand for US Treasuries, but they don’t tell us anything about supply. The government’s fiscal position determines that. And the fiscal position is, in a word, ugly.
Over time, the fiscal balance—the budget deficit as a percent of GDP—strongly correlates with the business cycle. When growth is strong (and unemployment is low), tax revenues rise and the budget balance improves. Right now, though, growth is strong and unemployment is low—and the budget balance is deteriorating, not improving.

Double click image to enlarge.

The culprit? The tax cuts and the spending package passed by Congress. The risk of a buyers’ “strike,” in which investors demand sharply higher yields for holding more U.S. Treasuries, spikes in these conditions. That’s not the base case in this forecast, but it would be a very ugly development.

So, how have these three factors combined to impact our forecasts?

Strong growth and rising inflation underpin our projection of higher interest rates. Rates have been expected to rise for a while, and so far the moves have been generally in line with forecasts. It's preferable to see rising growth expectations be the only driver of higher rates, but rising inflation will inevitably play some role. That’s why growth could stabilize, not continue to accelerate.

The fiscal indiscipline, though, is beyond what some expected. The effect—over time—will be unambiguously negative.

The Price of Abandoning Fiscal Discipline

As mentioned, fiscal deterioration increases the risk of a buyers’ strike. Again, that’s not a base case, and there is no way to forecast when—or if—a disruptive market event will happen. But we can say confidently that the risks of that scenario have risen. Even if that sort of disruption doesn’t happen, the lack of fiscal discipline—and the associated increase in the supply of U.S. Treasuries—is likely to push rates higher than growth and inflation suggest they should be.

The other big issue with expanding the budget deficit now: it’s harder to do it the next time the economy slumps. Fiscal stimulus makes sense in a downturn, but right now is exactly the time to be saving money to prepare for the next slowdown. When that time comes, the stimulus will cost a lot more than it needs to.

None of this is a reason to panic in the near term. Growth is strong, which can hide a lot of structural weaknesses. But higher deficit spending borrows from future growth to boost today’s growth. It’s better to have fuel to burn when the economy is weak than it is to toss fuel onto an already hot economy.

As we see it, rates should continue to rise in the next few months, and we’re watching closely for signs that rising inflationary pressure or an increasing debt supply could push rates up more sharply than we expect right now.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Eric Winograd
About the Author
Eric Winograd joined AB in 2017 as a senior vice president and senior economist responsible for the economic and interest-rate analysis of the U.S. From 2010 to 2016, he was the senior economist at MKP Capital Management, a U.S.-based diversified alternatives manager, where he produced thematic research to describe, illuminate and forecast the market environment for the firm’s investment team. From 2008 to 2010, Winograd was the senior macro strategist at HSBC North America, responsible for generating macroeconomic views for the firm's Private Bank Investment Group of the Americas and applying them to asset allocation, portfolio construction and tactical trade decisions. Earlier in his career, he worked at the Federal Reserve Bank of New York and the World Bank. Winograd holds a bachelor's degree in Asian studies from Dartmouth College and a master's degree in international studies from the Paul H. Nitze School of Advanced International Studies.

The value factor isn't dead, just misapplied

By Michael Hunstad, Guest Columnist

Contrary to popular perception, the value factor has outperformed over the last decade. Investors are losing patience with value strategies. They think the value factor has lost its power, underperforming since 2008. It hasn't. But there’s a difference between the value factor and value strategies. The value factor contributed positively to performance over the past decade. In contrast, many value strategies suffered from inefficiencies in portfolio construction.

Where’s the value?

The cyclical nature of the value factor’s typical return patterns demands patience. For example, the average historical cycle of underperformance of the value factor in developed markets has been approximately four years, based on research conducted by Northern Trust. Nonetheless, value strategies have historically rewarded patience over the longer term.

The firm illustrates the past decade’s apparent break from historical patterns by comparing the rolling three-year historical performance of the MSCI World Value Index to the MSCI World Growth Index (Exhibit 1). Over the 40 years preceding the global financial crisis, the MSCI World Value Index delivered fairly consistent outperformance with periodic cycles of underperformance. This pattern appeared to end abruptly in 2008. Since then, the MSCI World Value Index has underperformed its growth counterpart in nearly every rolling three-year period.

Double click image to enlarge.

Value strategy vs. value factor

Some people may use this chart to question whether the value factor works anymore. However, this chart does not represent the performance of the value factor. Instead, it shows the performance of a value strategy. This matters because a value strategy is subject to a number of return drivers including but not limited to value.

When we isolate various factors in Exhibit 2, we get a more accurate view of factor performance. The chart shows that value actually outperformed from 2008 to 2018. In other words, and contrary to popular belief, the value factor contributed positively to returns over the period.

Double click image to enlarge

Your value strategy may be corrupted

So, why have value strategies underperformed? Because many of the underperforming strategies inefficiently targeted the value factor, resulting in undesired or unexpected exposures.

Factor efficiency is a key driver of the risk-adjusted performance of factor-based strategies. We regularly see value indices or strategies without strong risk controls that structurally underweight the information technology sector and that display other industry biases, as well as having significant stock concentration. Furthermore, as the value factor tends to be negatively correlated with the quality and momentum factors, many value strategies are biased toward unfavorable low quality and low momentum stocks.

The negative contribution of these undesired or unexpected exposures overwhelmed the value factor’s outperformance over the past 10 years (Exhibit 3). This happened because, over the past decade, the information technology sector was among the best performers. A few very large information technology stocks significantly outperformed both the sector average and the broader market. As value strategies tended to avoid these stocks, this drove the negative stock-specific return contribution. Further, quality and momentum performed positively over the period, so value strategies’ under-exposure to them contributed to underperformance.

Double click image to enlarge

Strategy design and implementation matter

A robust investment process that explicitly accounts for the uncompensated risks discussed above can overcome such negative contributions. We believe that the value factor is not dead. While we expect the value premium to persist, it is critical to select a value strategy designed to target value precisely.

The views expressed do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Northern Trust or TEXPERS.

Michael Hunstad
About the Author
Michael Hunstad is the head of quantitative strategies at Northern Trust Asset Management. Prior to joining the firm, he was head of research at Breakwater Capital, a proprietary trading firm and hedge fund. Other roles included the head of quantitative asset allocation at Allstate Investments LLC and quantitative analyst with a long-short equity hedge fund. Hunstad holds a doctorate in mathematics, and master's degree in economics and a master's in quantitative finance. 

Managed accounts offer participants promise of 

more personalized asset allocation

By James Veneruso, Guest Columnist

Back in 1969, the Rolling Stones (inadvertently) summarized the state of decision-making facing plan sponsors regarding managed accounts. Due to limited product availability on recordkeeping platforms, plan sponsors may not be able to get what they want. But in looking at the choices they do have, they may be able to get plan participants “what they need.”

By taking into account factors such as outside assets, contribution levels, the existence of a defined benefit plan, and risk tolerance, managed accounts offer participants the promise of a more personalized asset allocation. According to Callan’s 2018 DC Trends Surveyjust over half of plan sponsors provide a managed account solution, and of those who do, nearly all offer it on an opt-in basis.

But there are often limited choices when it comes to selecting a managed account provider, with recordkeepers typically offering only one or two options. In many ways, the situation is reminiscent of the target date fund market a decade ago, when many recordkeepers allowed only their proprietary solutions.

And although prevalence is on the rise, plan sponsors and consultants must be aware that not all managed accounts are created equal. Before offering a solution, plan sponsors must understand that managed accounts differ markedly in their underlying methodology and interface. These differences, in turn, lead to allocations that could drastically vary. Ultimately, these differences will produce divergent participant outcomes. To be clear, there is no single “correct” methodology; each carries its own merits and deficiencies. But plan sponsors must understand the characteristics of their solution and document the process that led to offering it.

To demonstrate the differences in methodology and outcomes, Callan supplied three leading managed account providers with identical fund lineups and various sample participants. The table below illustrates the unique characteristics of these sample participants as well as the allocations generated by each of the providers. 

Double click immage to enlarge.

As shown, the various providers produced unique asset allocations that differed across aspects such as the use of passive strategies, the equity allocation, and fees. These allocations resulted in divergent projected outcomes (represented here by the one-year projected standard deviation). The results also demonstrate the ability of the providers to take into account participants’ self-perceived risk tolerance and unique goals (e.g., desire for a bequest).

In summary, plan sponsors and consultants should evaluate the underlying methodology and functionality of the managed accounts they are considering. Additionally, both should continue to press recordkeepers to offer a choice of providers and by extension underlying methodologies.

The views expressed do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Callan or TEXPERS.

James Veneruso
About the Author
James Veneruso is a senior vice president and defined contribution consultant in Callan’s Fund Sponsor Consulting group based in the Summit, New Jersey, office. Veneruso joined Callan in 2007 and is responsible for providing analytical support to Callan’s defined contribution clients and consultants. He is responsible for research and analysis of target date strategies and assists plan sponsor clients with target date manager searches and suitability studies.

Survey captures opinions of industry-leading 

private markets participants

Double click to enlarge.
Report findings submitted by Hamilton Lane Advisors

The current investment environment appears "bullish," at least that is the general sentiment of respondents of a newly released private markets survey.

Private markets asset management firm Hamilton Lane Advisors’ fourth annual survey offers a telling look into the private markets, capturing the insights and opinions of industry-leading investors and fund managers from around the world. This year's Private Markets Survey included a mix of 66 limited partners and general partners representing more than $2.9 trillion of global assets.

The firm's survey illustrates sector-specific and regional themes:
  • Unsurprisingly, private credit was a big theme as the strategy captured the third-highest amount of capital raised during the last three years. Twenty-four percent of general-partner respondents went so far as to say that, if they were investing their own money as a limited partner, they would allocate the most to private credit. Forty-one percent of limited partners have a current allocation to private credit that is at or above 5 percent. Further, 31 percent of limited-partner respondents plan to increase the most allocation to private credit, and not one respondent foresees negative returns for the strategy over the next five years.
  • Europe made a comeback this year, garnering a more positive outlook for the first time since the firm's 2013 survey. No respondents plan to decrease allocation to the Eurozone over the next two years. Instead, nearly 8 percent plan to increase allocations the most to this region. European public equity return sentiment also showed a dramatically more positive shift, where expectations in the 10 percent-plus return range almost doubled from 8 percent to nearly 16 percent year-over-year.
  • For the last three years, other buyouts – including SMID and buyout strategies other than large buyout – have been in the top slots for where investors plan to increase allocation the most, although the extent of which has been on a slight decline. Despite investors indicating they would allocate more to SMID buyout than large buyout over the past four years, large buyout actually saw the most fundraising - 23 percent for large vs. 16 percent for SMID. In the scenario of general partners investing their own money as a limited partner, large buyout made a comeback this year, whereas SMID buyout saw a pretty dramatic reduction in favor.
  • Throughout the private markets asset class, during the last several years there has been a growing emphasis by industry participants on improving operational practices, transparency and efficiency. A full 83 percent of Hamilton Lane's survey participants are reportedly dedicating real time and effort to improving their management and execution within their organization. Also, a full 94 percent expect their team size to grow over the next three years. While nearly 60 percent report relatively modest increases (1-20 percent) in their infrastructure/technology budgets, nearly 40 percent of respondents report that they are making meaningful investments (21 percent or more increases) in these budget areas.
The full survey is available on Hamilton Lane’s website here.

Hamilton Lane gathers and shares intel from many of the premier general partners, as well as some limited partners in the private markets. Included in the survey is a group of 27 leading and global general partners with diversified investment expertise, in areas including buyout, mid-market, credit, growth, natural resources, and venture capital, with an aggregate of more than $1.1 trillion in assets under management. Also included are 39 of the world’s largest limited partners, institutions including public pensions, endowments, family offices, corporate pensions, sovereign wealth funds, Taft-Hartley unions and insurance companies, representing more than $1.8 trillion in assets under management.

Hamilton Lane is an alternative investment management firm providing private markets services to investors around the world. 

The information contained in this report is based upon results of the firm's survey of a number of private market participants. The results of the survey may not necessarily represent the opinions of the firm or its employees, officers or directors.

Institutional investors have fiduciary responsibility 

for worldwide claims filing


By Mike Lange, Guest Columnist

By now, most institutional investors have concluded their fiduciary duty requires filing proof of claim forms in U.S. securities class action settlements. However, many have not yet implemented similar claims filing protocols for U.S. antitrust and non-U.S./Canada securities matters. If fiduciary duty compels the former, it also requires the latter; and none require funds to become named parties to active litigation.

Custodians won’t file these claims for clients, leaving fiduciaries to either devote internal time and resources or outsource this function to third-party filers. Either way, best practices suggest that fiduciaries take steps now to ensure their funds do not miss recovery dollars for lack of submitted paperwork.

In the U.S., antitrust class actions cover investments in non-securities financial instruments. At the end of 2016, the credit default swaps (CDS) settlement distribution showed fiduciaries that these claims can yield substantial dollars. For just nine antitrust matters there is currently more than $3.7 billion – and still millions of more dollars – that may be recovered in the future from non-settling defendants. There are also more than 50 antitrust class actions in active litigation which could yield filing opportunities and substantial recoveries for years to come. 

Double click image to enlarge. 

There is a common misconception that non-U.S./Canada securities recovery efforts require funds to be named parties in active litigation. Since 2015, roughly 100 non-U.S./Canada securities matters were pursued. More than 70 percent were in jurisdictions using ‘opt-out’ classes and/or analogous administration processes.
Double click image to enlarge.

Here are few examples: 

  • Australia/Israel: Roughly 30 matters were pursued in Australia and Israel. Both countries use ‘open’ or opt-out classes that like U.S. class actions, encompass all investors affected by alleged frauds during relevant time periods and/or utilize claim registration processes similar to U.S. class action administrations.

  •       Netherlands
      The five matters brought in this country fall into two categories:
  1. Collective action: These suits are prosecuted by representative plaintiffs. If they prevail on questions about defendants’ liability, they are followed by individual claim resolution procedures.
  2. Collective settlements: Dutch Foundations are special purpose entities created to litigate in their own name questions about the defendant’s liability. When settlements are reached, Dutch Foundations use claims filing and administration processes like those in the U.S. Dutch law includes other legal mechanisms that don’t require funds to be active litigants including court investigations that can be triggered by requests from at least 1 percent of company shareholders.

  • Other: Beyond these three countries, other examples of non-U.S./Canada matters that involve claim submission include regulatory enforcement resolutions with investor compensation aspects like the Tesco Comp Scheme in the UK, which resembles an SEC Fair Funds administration in the U.S.

For fiduciaries, the key is to have a system in place to identify non-U.S./Canada matters that involve claims filing, as opposed to active participation as a litigant. As with U.S. securities settlements, claims filing for U.S. antitrust class actions and non-U.S./Canada securities matters can be automated thus maximizing recovery dollars and efficiently allocating staff time and resources. 

The views expressed do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Financial Recovery Technologies or TEXPERS.

Michael Lange
About the Author
Michael Lange is counsel of securities litigation for Financial Recovery Technologies. Financial Recovery Technologies is a  technology-based services firm that helps institutional investors identify eligibility, file claims and collect funds made available in securities class action, global and antitrust settlements.

Should plan sponsors consider Bitcoin 

for retirement plans?

Bitcoin is a digital currency and worldwide payment system. It is the first decentralized digital currency, as the system works independently of a central bank or single administrator. Encryption techniques are used to regulate the generation of units of the currency and verify the transfer of funds.

By Charles Hodge, Guest Columnist

One of the requirements of retirement plan fiduciaries is to remain diligent, looking for ways to earn a return and protect capital in a prudent manner. Pension plans are looking for ways to add return while controlling risk, frequently through asset classes that offer diversification and attractive risk-adjusted returns. When plan sponsors look to commit capital to an asset class, they demand accurate information, transparency, and trust. No matter how attractive the historical return, plan sponsors and trustees must behave as prudent fiduciaries.

Bitcoin, as a cryptocurrency, is not backed by any government, commercial institution, or measurable asset or commodity. It is a digital promise backed by encryption and passwords. How does bitcoin fit in with the goals of plan sponsors?

Let’s examine a few issues:

·    Capital preservation: Fiduciaries need to know the expected upside of their investments and the risk of capital loss. Because cryptocurrency cannot be held and only exists as lines of computer code, the chance of it vanishing completely would be a concern to a plan sponsor who must have assets held independently in the custody of a trust company. Their value is based on limited supply and demand-driven price. One or two sizable thefts or the failure of a key bitcoin broker and demand could plummet, significantly diminishing the value of the plan sponsor’s holdings.

·    Expected return: Investors buy assets to generate returns, with dividends and interest or an increase in price. Frequently they will examine historical returns and risk premia. Return-since-inception for bitcoin is certainly attractive. It’s currently unclear how bitcoin’s future return would be modeled. Bitcoin doesn’t pay interest (though some cryptocurrencies do pay implied dividends), so the only source of earnings is a price increase. The expectation would have to be for increasing demand for a stable supply, a broader adoption as a medium of exchange. With new cryptocurrencies coming online, it’s hard to know how to measure this future supply/demand equilibrium and how that would affect price.

·    Asset classes: While bitcoin’s long-term returns look attractive, it also would seem to provide diversification. Plan sponsors are usually looking for asset classes that help their risk-adjusted returns: a higher Sharpe Ratio. Cryptocurrency cannot be held in custody like gold and it does not have any other use (industrial, jewelry, etc.). Gold, while not as portable as bitcoins, has a worldwide market. And while cryptocurrencies can be bought and sold quickly, converting them to other asset-classes is not as easy as many other plan sponsor holdings. In times of global distress or market corrections, it will likely be even more difficult.

·    Valuation: Owners of assets want to know what their holdings are worth. It’s unclear what the “value” of a bitcoin is because it’s not anchored to a purpose like dollars, euros, platinum, silver, etc. Former Federal Reserve Chair Janet Yellen called the cryptocurrency a “highly speculative asset,” saying it is not a stable source of value.

·    Intrinsic value: One of the biggest challenges of bitcoin is its intangible nature. How does an investor compare the value of bitcoin against monero, Zcash, Ripple, or other digital currencies when there are no earnings, assets, or other typical valuation metrics?

·    Custody: Many asset classes, including stocks and bonds, could be subject to theft or fraud so the role of the custodian is important to establish ownership. How do you establish custody for an asset that is only digital code and a password? Because the trades are anonymous and untraceable, how secure is a simple password? With a “hard wallet” and a couple of keystrokes, an untraceable trade could wipe out a plan’s account with no way to track down the offender.

·    Security: Plan sponsors remain concerned about security and access. Identity theft is on the rise, with hackers attacking 401(k) plan balances and pension benefit payments. Cryptocurrencies remain a significant target for hackers and thieves.

·    Governance: Because bitcoin exists outside the oversight of banks and regulators, it’s hard to know how disagreements can be resolved. As an owner of a cryptocurrency, do you have trust in the governance of the rules of ownership and trading?

At this time, bitcoin and other cryptocurrencies are not appropriate for retirement plan sponsors. Broader institutional market adoption such as futures, shorting, and opportunities to arbitrage might bring pricing efficiency and predictability that could make it an attractive asset class, but these market forces are in the early stages of development.  

To note, cryptocurrencies such as bitcoin rely on blockchain technology; these are distinct concepts and should be viewed separately when considering retirement investment opportunities. Institutional investors will likely own businesses that take advantage of blockchain technology, but it’s this author’s opinion that bitcoin isn’t ready for plan sponsor prime time. To read the full article, go to

The views expressed do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Milliman or TEXPERS.

Charles Hodge
About the Author
Charles Hodge is an investment services consultant in the Dallas office of Milliman. He has worked with investments for more than 20 years and has been an institutional investment consultant since 1991. Charles joined Milliman in 2000.

Stock market volatility mostly due to 

talk of a global trade war

By James R. Kee, Guest Columnist

Volatility has certainly returned to the stock market this year, largely due to growing fears of a global “trade war.” A trade war means that each country seeks to restrict imports from other countries by placing tariffs or restrictions (quotas) on them. It is feared that each such effort by one country will lead to “retaliatory” measures taken by other countries. 

We have seen some of this in the rhetoric between the U.S. and China this year. When President' Donald Trump's administration proposed tariffs on steel and aluminum imports from China, China in-turn threatened to place tariffs on U.S. agricultural goods going to their country.

A great historical example of a trade war occurred after the Tax Act of 1930, also known as the Smoot-Hawley tariff, which was sponsored by Sen. Reed Smoot and Rep. Willis Hawley. Jude Wanniski, an associate editor of the Wall Street Journal in the 1970s, chronicled how the stock market crashed in 1929 after the Senate coalition to block the Smoot-Hawley tariff from passing fell apart (also published in his 1978 book, "The Way the World Works"). Thirty-five nations opposed the legislation and threatened retaliation, which they did as a trade war ensued. Between 1929 and 1932 imports fell by two thirds and exports fell even more, according to economist Charles Kadlec’s unfortunately titled 1999 book, "Dow 100,000." So markets react poorly when the interconnected global web of production and exchange gets threatened.

That’s because stock markets price future wealth creation, and wealth is created through production and exchange. Of these, exchange is the most import. Value can be created through exchange merely by moving resources to their most highly valued uses. Not so with production. When global exchange is lessened, people, plants and firms (i.e. production) that made sense in a global economy become redundant in a local economy. That is, they are no longer needed. That is why stocks sell-off when trade-war rhetoric heats up.

Most presidents have dabbled with tariffs from time to time, but usually as temporary and/or one-off actions. On the blackboard, free trade always has winners (consumers get cheaper goods) and losers (displaced workers), but it tends to be wealth enhancing because the winners gain more than the losers lose. But because the losers are easy to identify (e.g. steelworkers) while the winners are diffuse (U.S. consumers), there is always political pressure to help the losers without fear of retribution from the winners. That’s why talk of trade restrictions never really goes away. 

Plus, many countries do cheat on trade agreements, at least by U.S. standards. For example, China heavily subsidizes many industries and often requires technology transfer (sharing) as a pre-condition for doing business there. More subtle ways of cheating include failure to comply with World Trade Organization environmental and labor rules, subsidizing or propping up “zombie” companies, and passing government procurement laws (which are almost universal) that require buying from domestic (local) producers. 

Let’s hope the current trade rhetoric results in better trade law compliance by all counties, not in a trade war.

The views expressed do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of South Texas Money Management or TEXPERS.

Jim Kee
About the Author
Jim Kee is president, chief economist and a partner with South Texas Money Management. He joined the firm at the beginning of 2009. He was named the president of the firm in April 2011. Kee's expertise lies in combining top-down, macroeconomic insights with bottom-up stock selection tools. He works with both the investment research group and the investment advisors at South Texas Money Management.

Global Industry Classification Standard to review information technology weighting 

By Romina Gravier, Guest Columnist

The nature of emerging markets has been changing, and information technology has become the most dominant sector in the MSCI Emerging Markets Index, an analysis tool created by Morgan Stanley Capital International. In this respect, the recent announcement by MSCI and Standard & Poor's of a review of the Global Industry Classification Standard will shake things up.

A key outcome of the review will be a significant reduction of the Information Technology, or IT, weighting in the index. Despite the lower IT weighting, however, I believe technologically innovative companies will continue to have a dominant role in emerging markets.

The nature of emerging markets has been changing. As the chart below shows, over the past 10 years, the MSCI Emerging Markets Index has experienced a structural shift toward IT at the expense of heavyweight commodity sectors. The change is even more pronounced compared with 20 years ago when IT only represented 5 percent of the index. The Internet Services & Software industry, which is led by the so-called “BAT” companies (Baidu, Alibaba, and Tencent) and now accounts for more than 10 percent of the index, has been a key driver of the increase in the index’s IT sector weighting.

Double click image to enlarge.
But the increase is not exclusively due to these companies; many emerging market companies are at the forefront of the technology revolution. Moreover, technology-enabled business models are prospering beyond the technology sector, across different industries, from financial services to consumer sectors.

It is not surprising, given these changes, that MSCI and S&P recently announced a review of the Global Industry Classification Standard, which was developed in 1999 to organize companies into industrial groupings based on similar production processes, products, or behavior. The GICS structure currently consists of 11 sectors, 24 industry groups, 68 industries, and 157 sub-industries into which all major public companies are organized.

A key outcome of the GICS review on the MSCI Emerging Markets Index will be that the index’s information technology weighting will decline by nearly half, mostly in favor of Telecommunication Services, which will be renamed Communication Services. The bulk of the IT weighting reduction will come from the discontinuation of the Internet Software & Services industry. The rationale, according to S&P and MSCI, is that the industry “has become too large and diverse to be useful for analysis or index construction. It has evolved to include new business models using internet technology to cater to a variety of end users and industries. A majority of respondents [to a survey MSCI and S&P conducted prior to announcing the changes] now regard the internet as simply a medium for delivery of a company’s products and services.”

One result of this change will be the reclassification of Tencent and Baidu from the IT sector into the Communication Services sector, while Alibaba will join the Internet & Direct Marketing Retail industry in the Consumer Discretionary sector. In other words, the BAT will no longer be in the IT sector. That’s quite a change. An approximation of the MSCI Emerging Markets Index weighting changes based on the most recent information disclosed by MSCI is shown below.

Double click image to enlarge
The index’s increased weighting in the new Communication Services is largely driven by two factors. The first is the reclassification of a large part of Internet Services & Software industry as described above. The second is the movement of the Media industry group from the Consumer Discretionary sector into the Communication Services sector. MSCI’s rationale for the latter is the acknowledgment of the convergence between content creation and delivery—that is, between media and telecommunications companies. This loss to the Consumer Discretionary sector, however, is more than offset by the new inclusion of Alibaba and other such companies in the Internet & Direct Marketing Retail industry in the Consumer Discretionary sector.

Company fundamentals are agnostic to index classification, and fundamental active management should be as well. Nevertheless, investors will likely be affected by GICS changes as sector profiles will become more blurry. In particular, the IT and Communication Services sectors will be meaningfully altered, thus making historical comparisons difficult.

Stripped of some of its most secular growth components, the new IT sector’s growth profile will diminish, as will its valuation. Based on some estimates, the IT sector’s one-year historical earnings-per-share (EPS) growth rate will decline from 30.6 percent to 16.5 percent and its price-to-earnings (P/E) ratio will decline from roughly 15 to 10, as the table below shows.

Double click image to enlarge.
Conversely, the historically low-growth Telecommunication Services sector will morph into a fast-growing, innovative Communication Services sector (with expected long-term growth soaring to 31.5 percent versus 14 percent for the old Telecommunications Services sector).
These changes will make historical comparisons hazardous and will certainly pose challenges to investors who attempt to gain exposure to fast-growing, innovative companies in emerging markets blindly through passive sector strategies.

The lower IT weighting doesn’t mean that there will be any less technology or innovation.
Moreover, despite the lower IT weighting, I believe technologically innovative companies will continue to have a dominant role in emerging markets over the next decades.

For example, according to TechCrunch, 40 percent of the world’s so-called “unicorns” (which are start-up companies worth more than $1 billion) are in emerging markets, and South Korea tops the league of most innovative economies in 2018, based on the Bloomberg Innovation Index.

In addition, the Chinese government’s continued support to its technology champions and backing of start-ups in the “internet of things” (the network of physical devices, vehicles, home appliances, and other items embedded with electronics that allows them to connect and exchange data), smart appliances, and high-end consumer electronics will continue to drive technological innovation.

Whether these companies are now categorized in Communications Services, Consumer Discretionary, or even Financials or Industrials sector, the lower IT weighting does not mean that there will be any less technology or innovation.

Note: The GICS changes mentioned in this note will be implemented at the end of September 2018. They will affect all MSCI and S&P indexes, both in developed and emerging markets.

The views expressed do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of William Blair or TEXPERS.

Romina Graiver
About the Author
Romina Graiver is a portfolio specialist for William Blair's global equity strategies. In this role, she participates in the team's decision-making meetings, conducts portfolio analysis, and is responsible for communicating portfolio structure and outlook to clients, consultants, and prospects. Previously at William Blair, she was a senior client relationship manager. Before joining William Blair in 2012, Graiver was deputy-head of the international equity investment team at BNP Paribas Investment Partners, where she was responsible for product development and investor communication.