Ins and Outs of Emerging Markets Investing Part 2: Portfolio Management and Trading

In the first part of this two-part series, “Ins and Outs of Emerging Markets Investing: Market Behavior and Evolution,” we put the recent performance of emerging markets into a longer-term perspective and discuss the opportunity set presented by emerging markets. In this article, we discuss the importance of effective portfolio management in helping investors capture their fair share of returns in emerging markets and highlight key elements of Dimensional’s approach.

Since Dimensional first started investing in emerging markets in late 1993, we have implemented changes in our eligible investment universe that reflect the evolution of emerging markets as a whole. We consider a combination of qualitative and quantitative criteria to determine which countries, exchanges, and securities are eligible for investment in our emerging markets portfolios and global portfolios that include emerging markets. Those considerations include the costs and frictions associated with accessing these markets and apply certain minimum criteria in areas like market liquidity, adequate regulation at the exchange level, listing requirements, and reasonable accounting standards. For example, following several years of evaluation, the Dimensional Investment Committee in 2019 approved China A-shares, the United Arab Emirates, Saudi Arabia, and Qatar for investment. The addition of countries that meet Dimensional’s eligibility criteria enables us to pursue potential diversification benefits in strategies that invest in emerging markets.

Our global investment team coordinates portfolio management and trading activities in these markets. Our expertise in overseeing securities lending, analyzing and electing on corporate actions, implementing strong stewardship practices, and trading equities and currencies in multiple regions contributes meaningfully to our ability to invest efficiently in emerging markets.

Dimensional engages in securities lending in many of our equity portfolios with the goal of adding revenue to those portfolios and improving returns for investors. Total lending revenue from our global commingled funds with a dedicated emerging markets focus contributed approximately $95.7 million, or 15.9 basis points, to those funds for the one-year period ending June 30, 2020.

We engage in securities lending in the local markets of countries that meet our requirements as well as in the US for American Depository Receipts (ADRs) that provide exposure to emerging markets companies. Lending in multiple markets requires robust systems, integration with global portfolio management processes, and close coordination with securities lending agents.

Korea and Taiwan are examples of emerging markets that have contributed meaningful lending revenue but require a heightened degree of coordination and risk control due to strict local market regulations in areas such as trade settlement. We implement sophisticated risk management and investment systems that allow the portfolios to meet the lending requirements in these markets, such as presale notification to lending agents, in order to capture the benefit of lending there.

Our portfolios are designed to be highly diversified, in some cases holding thousands of securities, so we regularly handle a variety of corporate actions ranging from dividend payments to large tender offers. In emerging markets, common types of corporate actions include rights offerings, subscriptions, and various types of tender offers. For most types of corporate actions, we avoid defaulting to standing instructions with custodian banks. Standing instructions involve less effort and coordination but may not always result in the best economic value for the portfolios.

Seeking the best outcome for portfolios across all types of corporate actions involves managing scale, complexity, and a high degree of coordination. Over the one-year period ending June 30, 2020, Dimensional elected on approximately 500 events in emerging markets, as well as 75 events in the US and 2,200 events in developed markets outside the US. We frequently make elections across multiple accounts, for which different criteria may apply in areas such as security eligibility and tax implications.

For some types of events, there are many tradeoffs to consider. For example, for Korean rights offerings, investors generally have the choice of exercising the rights, allowing them to lapse, or selling them on the market. Exercising allows us to maintain our ownership level in the company and can have significant intrinsic value but often requires the cost of a foreign exchange trade. Potential proceeds of selling on the market need to be weighed against the cost of commission, ticket and other transactions charges, and potential capital gains tax.

Korean merger consents are another example of how complex voluntary corporate actions can be. For large-scale merger events in Korea, the acquirer is required to offer a buyback of their shares. If there is sufficient intrinsic value in the buyback, we will typically dissent via both the corporate action and proxy vote and potentially tender our shares in a separate corporate action. This requires the Portfolio Management team to coordinate not only with the Investment Stewardship team, but also the tax team because of the documentation required to avoid capital gains taxes. It also requires a flexible approach to portfolio management. Our highly diversified portfolios give us flexibility to hold or tender shares of a single company without meaningfully altering the overall portfolio characteristics. And our daily portfolio management process allows us to evaluate and elect on such corporate actions in a timely manner, maximizing the expected benefit for shareholders.

Stewardship at Dimensional is considered an important investment function that is integrated with portfolio management. Globally, we implement custom policies designed to focus on protecting and enhancing shareholder value. Our Investment Stewardship group regularly reviews the regulations governing proxy voting in every market where we invest. We consider explicit costs as well as opportunity costs, such as market impediments that may restrict trading around voting dates, to determine our eligible universe of markets in which we vote. For our most recent proxy voting year (July 1, 2019 to June 30, 2020), we voted in over 14,500 shareholder meetings globally, including over 5,400 in the emerging markets.

In addition to voting proxies, we also engage¹ with portfolio companies on a range of environmental, social, and governance topics. One recent example in emerging markets involved conversations with a Brazilian multinational company engaged in metals and mining to discuss the company’s response and action and the board’s oversight around a recent dam collapse. Another involved engaging with a South African gold miner to better understand the board’s oversight of material environmental, social, and governance risks in light of a recent high-profile strike at one of its mines and two small-scale dam failures. For more information on Dimensional’s approach to stewardship, see our Investment Stewardship page. 

The broad diversification of our equity portfolios is beneficial as it helps reduce stock, sector, and country specific risks, improves the reliability of expected outperformance, and provides more flexibility in execution. However, getting efficient exposure to a broad portfolio of large, mid, and small cap stocks in emerging markets requires implementation expertise. We have a demonstrated ability to efficiently manage and trade broad market exposure in these markets and a long history of doing so.

In many markets, investors frequently have the option of trading more than one line of shares issued by an emerging markets company. For example, Chinese companies that have an “A” share listed on a local exchange may also have an “H” share listed in Hong Kong and/or in some cases an ADR trading in the US or Global Depository Receipt (GDR) trading in another market. Another example is Thailand, which has restrictions on foreign ownership that may result in local vs. foreign shares trading for the same stock but potentially at different prices and volumes. As part of our implementation process, Portfolio Managers evaluate which line would be most beneficial, taking into account multiple considerations, such as prices, costs, liquidity, market regulation, and sometimes taxes, all of which can fluctuate over time. This dynamic approach contrasts with a more static approach of tracking the lines held by an index.

Dimensional also uses a dynamic approach when it comes to trading. We seek to reduce our implementation costs by using a flexible trading approach that participates in the available market liquidity. To do that effectively, we conduct ongoing rigorous research on how to price, size, time, and route our orders differently across different markets around the globe in order to account for differences in their market microstructures, regulations, and trading conventions. For example, in India, trading tends to be characterized by relatively tighter bid/ask spreads, smaller size trades, and higher volumes, but in Indonesia, trading tends to be characterized by relatively wider bid/ask spreads, larger trades, and lower volumes. Differences in these types of trading conventions are more pronounced in emerging markets than in developed markets, where they are generally more uniform. Through our regional trading teams, we also have real-time oversight and communication with local market participants, which enables us to adapt in a timely manner to changes in local regulations and trading venues.

The foreign exchange market is a globally decentralized over-the-counter market for trading currencies. The market is unique in its deep liquidity, geographical dispersion, continuous operation, and complexity. Dimensional engages in foreign exchange markets on a 24-hour-a-day basis, trading currencies at the time when they tend to be most liquid. Where possible, we net foreign exchange transactions in the same currency across accounts to reduce costs. Our Portfolio Management and Trading teams control our foreign exchange trading to the extent possible. Whenever possible, we put foreign exchange trades into competition across multiple market participants with the goal of obtaining the best pricing.

Trading in certain emerging markets currencies involves navigating restrictions and/or operating constraints. Trading restricted currencies, such as the Indonesian rupiah or Thai baht, requires operational expertise to meet country-specific regulations within prescribed timeframes. Often managers outsource these trades to custodians, which can result in increased costs and decreased price transparency. Dimensional’s expertise in controlling our foreign exchange trading often leads to better investor outcomes, especially in emerging markets, where costs can be large and penalties onerous.

An important part of our foreign exchange process is conducting systematic, in-depth post-trade monitoring of all currency trading. For emerging markets in which competition is restricted, collecting and evaluating data can be challenging, but these efforts help us improve our trading approach over time. Because we trade currencies ourselves across multiple custodians, we are able to gather and apply large data sets to improve transparency and increase accuracy in trade costs analysis.

The emerging markets landscape has continued to evolve over the past few decades, contributing to a broader set of opportunities for investors. However, expertise is needed to efficiently navigate these rapidly changing, heterogenous markets.

Dimensional has managed emerging markets equity strategies since 1993, offering investors broadly diversified exposure to emerging markets equities with systematic pursuit of higher expected returns. Through our decades of experience, we have built robust, systematic, and scalable processes for securities lending, corporate action execution, stewardship activities, stock trading, and currency trading. Our expertise enables us to pursue opportunities to improve performance and reduce costs every day in every emerging market we invest in.