China and India Power Huge Asia Pacific ex-Japan Returns
A review of the Morningstar Asia Pacific ex-Japan category, which includes funds with at least 7
5 per cent of total equity assets in Pacific markets and less than 10 per cent in Japan, revealed that annualised returns over the last five years have been north of 25 per cent. Performance over the last three years has been even more enriching, with returns hovering in the vicinity of 33 per cent.
A relatively high exposure to markets such as India, South Korea and China (including Hong Kong) has powered the meteoric returns of top quartile funds. The areturns from these hot Asian markets over the last five years tell the tale - MSCI India and MSCI Free China are up nearly 45 per cent each on an annualised basis; MSCI Korea has gained 26.2 per cent per year and MSCI Hong Kong has returned 21.4 per cent per year.
Many Funds Lag Market Benchmarks
But even as funds in the Asia Pacific ex-Japan category have generated staggering absolute returns, a majority of them have failed to beat the MSCI AC Asia Pacific ex-Japan index. Out of the 126 funds included in our study, comprising offshore and onshore offerings with a three-year track record and available for sale in the UK, only about a third have outperformed the index over the last five years and less than half outperformed over three years to 30 November. While this dominance of the index in a strong up markets is not entirely unexpected, what is surprising is the trend stubbornly persisted over down market years (2001 and 2002) as well.
Identifying Top Asia Pacific ex-Japan Performers
In light of this, should investors simply opt for an index tracker when seeking Asia exposure? We think that's a reasonable way to go, but be careful how you go about fund selection as returns can vary appreciably. While several major indices represent the investible universe in the region - MSCI Asia Pacific ex-Japan, MSCI AC Far East ex-Japan, and FTSE World Asia Pacific ex-Japan to name three prominent ones - there are important differences among them. For instance, India and New Zealand are excluded from the Far East ex-Japan index but included in the Asia Pacific ex-Japan index, which has outperformed the other two indices over the last one, three and five years to 30 November. Available trackers include HSBC Pacific Index, L&G Pacific Index, SSgA Asia Pacific ex Japan Equity Tracker, and the ML Pacific ex-Japan Equity Tracker.
There are also a handful of actively managed funds that have beaten their indices with some consistency. For example, Templeton Asian Growth and Fidelity South East Asia have posted top quartile returns over both three and five-year cumulative returns. We particularly like Angus Tulloch, manager of the First State Asia Pacific fund, for his long term outperformance during varying market conditions. He is a highly experienced manager, who follows a disciplined investment process. Tulloch pays more attention to quality, which means he tends to do better in down market years than in up market years when stocks markets reward investors indiscriminately. His fund was top quintile over 2000-02, a weak period for Asia overall, and top quartile over the last five years as well.
What Risks Lie Ahead?
Investors opting for an Asia-focused fund at this juncture should be especially attuned to risk, however. As dust storms gather over global equity markets, in particular the US, it is paramount that investors keep at least one eye firmly focussed on risk inherent in emerging markets.
First and foremost, owning a geographically balanced portfolio is critical at this point in the market cycle given that the Asian exuberance is now running in its fifth consecutive year. Investors have significantly increased their exposure to both Asia Pacific funds and emerging markets offerings in recent years, and the two sectors tend to have significant overlap. For example, the MSCI Emerging Markets and MSCI AC Asia Pacific ex-Japan indices have a performance correlation of 0.96 (with 1.0 indicating perfect correlation) and the spread between the index weight of key overlapping component countries such as China and India is less than 250bps. It is paramount investors are fully aware of the true extent of their China (including Hong Kong) and India exposure via funds residing in different sectors. Moreover, investors should keep their expectations in check. China, India and Australia have all had strong runs over the last few years and it is open to question whether this degree of outperformance can be sustained for very long. Furthermore, political risk tends to be an important one in Asia, as investors in Thailand learned recently about the fragility of Asian regimes.
While a geographically balanced portfolio is not a panacea for all global or regional disturbances, it will undoubtedly soften the blow should fears of a US-led global slowdown in 2008 come to fruition.
