Dear friends,

We live, indeed, in interesting times.

You might think you hear in that statement an echo of “an ancient Chinese curse, ‘may you live in interesting time.’” Yes and no. I was thinking of the phrase but it’s not ancient. Also not Chinese. It appears to have been invented in 1936 by a member of the British foreign service who was trying to sound … uh, profound.

The sentiment remains, though the source is not exalted.

Turmoil, likely deepening, in Washington. Turmoil, likely coming to a head, in London. Turmoil, without a clear path out, with Beijing. Sunny days for the American consumer, dark ones for American industries. Economists place the odds of a recession in 2020 (or 2021) at 31-35%, or 40% or almost 50%, or 75%. Unless it’s all good. They’re economists. It’s always like that.

“John, do you think you could find me a one-armed economist?” plausibly attributed to Harry Truman, ca 1947.

The Financial Times asks whether we’re ready “for the Doomsday Dollar scenario” (9/29/2019) and the Wall Street Journal pipes in with the observation that the breadth of the stock market’s advances is collapsing (9/30/2019).

And no, I’m not forgetting young Greta Thunberg and her infamous glare. When it’s 87 and humid on the first of October, you’re experiencing another bout of river flooding, and the crops that should be ready for harvest aren’t close, it’s hard to set such concerns aside.

As scary as the news of the day might be, we do need to remember that long-term investments require a longer term perspective. In this issue of the Observer we try to balance those concerns. Charles Boccadoro and Lynn Bolin both present metric-centered pieces on dealing with the downside and positioning your portfolio for negative short-term events. (Spoiler alert: Lynn’s analysis points to impending recession and an allocation of just 20% to equities.)

As a sort of counterpoint to that essential concern with the here-and-now, I return to the task of thinking about compelling long-term opportunities with a profile of Crawford Dividend Opportunity (small cap + equity income = outstanding long-term performance) and Invenomic Fund (which now has most of its former Balter hosts onboard), a Launch Alert for Grandeur Peak’s long-planned Global Contrarian fund (read quickly, GP is really serious about their capacity constraints) and an updated report on emerging market value funds (Seafarer Overseas Value has been kicking … uh, up a fuss). We hope the balance helps.

Thanks, as ever …

It might well be irrational to celebrate having nine (9!) subscribers (in the sense of folks who’ve set up to make ongoing monthly contributions in support of the Observer), but we’re celebrating because that’s a new high and they’re cool people. So thanks, as ever, to the folks at S& F Investment Advisors, Greg, William, Doug, William, Brian, Seshadri, David, and our newest subscriber, Matthew. Thanks, too, to Michael from Ontario, New York for his support.

And to you all, for reading and reflecting with us. I’d be especially delighted to meet any of the folks who might be attending the annual AAII convention in Orlando in a few weeks. I’ll be there, speaking … well, at around the time most convention attendees will be boarding their flights home. Such is life. It will give us the opportunity to have a nice discussion with the folks who do attend. The theme of my presentation is how to be a long-term investors in a world filled with … well, sound and fury, signifying nothing.

In November, we’ll look a bit at Castle Focus (which has caught Ed’s attention) and North Star Dividend (which has caught mine); like Crawford Dividend it’s a small cap fund with a strong dividend focus which means it lives in both the conservative Equity Income and aggressive Small Cap camps. Perhaps a fund for our times? The pipeline will be filling for year-end fund and ETF launches.

Stay tuned!

Investors are interested in returns: the answer to the question, “how much are you going to make me?” Sophisticated investors are interested in how those returns are delivered.

Over the current market cycle, Fidelity Blue Chip Growth (FBGRX) has returned 10.7%, among the best of all funds. AMG Yacktman Focus (YAFFX) trails it at 10.5% and costs a lot more to boot (1.27% versus 0.72%). On surface, that’s pretty clear: Fido offers better performance, lower costs.

But that masks some important differences. Fidelity posted a loss of -48.8% in 2009, Yacktman’s was -38.3%. Fidelity bounces a lot more, in general: it has a standard deviation of 17.3 against Yacktman’s 14.8. Standard deviation is a surrogate for “normal” bounciness: returns of 10.7% and a standard deviation of 17.3 translates to, “in two years out of three, you might expect your returns to be 10.7% plus or minus 17.3%.” So, somewhere between a 28% gain and a 7% loss. If you don’t find that range reassuring, you’re beginning to discover the allure of low volatility funds.

A huge variety of risk-return metrics exist to help us simplify the task of adjusting returns to account for the risks you might reasonably expect: Sharpe ratio (for which the originator received a Nobel Prize), Sortino ratio, Martin ratio, Ulcer index (which factors together how far a fund falls with how long it stays down to help you understand how much of an ulcer it might give you), information ratio and others.

From an average investor’s perspective, the problem with all of them is the same: it’s never easy to say what number is “good.” Is a Sharpe ratio of 2.44% good? What about a Martin ratio of 14.3 or an Ulcer index of 0.1?

And that’s where the capture ratio comes in. The capture ratio offers an unambiguous answer to the question, “is that good?” If the capture ratio is above 1, the answer is “yes.” The farther above 1, the stronger the “yes.”

Here’s our official explanation of it from the MFO Premium definitions page

Capture

Amount of positive or negative return a fund captures relative to various indexes, measured over evaluation period specified. Currently, we calculate performance against each of four indexes: the S&P 500, the Barclays US Aggregate total bond index, a US balanced 60/40 index and the MSCU All Countries except the US index.

Here are the specific Capture Metrics:

Upside Capture compares the positive return of a fund, comprised of positive month ending returns, to one of four indexes, over evaluation period specified. So, compared to SP500, an Upside Capture of 120% means the fund retuned or “captured” 20% more positive return than SP500 over the evaluation period specified.

Downside Capture compares the negative return of a fund, comprised of its negative month ending returns, to one of four indexes, over evaluation period specified, measured in percentage. So, compared to SP500, a Downside Capture of 80% means the fund retuned or “captured” only 80% of downside that the SP500 over the evaluation period specified.

Capture Ratio is simple the ratio of Upside To Downside Capture. Values greater than 1.0 means that a fund capture more upside than downside compared to its reference fund … a good thing!

To use the capture ratio, you need three things:

1. comparable funds
2. a relevant benchmark
3. a meaningful time frame.

Let’s say you’re anxious about the likely performance of traditional 60/40 funds as the long joint bull markets for stocks (since 2009) and bonds (since 1982) near their end. Several market research groups, including Research Associates and GMO, estimate the returns of traditional 60/40 balanced over the next 5-10 years at, well, zero. One alternative to a 60/40 fund might be a long/short equity fund, many of which give you about a 60% net equity exposure. In theory, their short positions might generate some gains in volatile markets and give them a risk-return profile better than a traditional 60/40 fund’s.

You might then decide that you’d like to look at the performance of long/short equity funds, against the 60/40 index over the past 18 months because that’s been a period of substantial volatility. (And, too, being of modest means and interested in purchase, you’d want the funds to be open and available for under $10,000.) I used the fund/ETF screener at MFO Premium to find the long/short equity funds with the highest capture ratio relative to a 60/40 balanced index.

The blue-banded funds are MFO Great Owl funds; they have achieved top 20% risk-adjusted returns in every trailing measurement period longer than one year.

Three things quickly stand out:

1. some of these funds appear to be relatively volatile, despite short term success. NUXIX captures 190% of the upside and 142% of the downside of a simple 60/40 index. That’s probably a bad fit for someone seeking a conservative core investment. Alger and Highland, likewise, are a bit challenging.
2. some of the funds are awfully sedate, producing bond-like returns. The AGFiQ ETF, for example, is capturing under half of the movement – and generating half of the returns – of the index. Those might be a bit mild.
3. James Alpha appears to be the mildest mannered winner in the group: it about matches the 60/40 index while capturing just a third of its downside. RiverPark shows the best balance, substantially beating the group with only slightly less capture on both the upside and downside.

The capture ratio helps identify a bunch of funds worthy of further investigation: they outperform the traditional 60/40 crew with noticeably less downside risk. Since this screen was very short term, you’d want to explore the manager’s longer-term performance and philosophy.

A more straightforward experiment might be to find a new core fund: a domestic large cap fund that has a capture ratio higher than 1.0 against the S&P 500 over the entire market cycle, which is also open to retail investors. Here’s the top of the list:

The blue-banded funds are MFO Great Owl funds; they have achieved top 20% risk-adjusted returns in every trailing measurement period longer than one year.

What stands out? All of these funds have better risk-return profiles than the S&P 500, which is signaled by their capture ratios above 1.0. Look at the down capture column. None of the funds with great long-term success has a down capture over 100. For the most successful funds, the average downside capture is just 86% while the average upside capture is 98%.

Here’s the translation: the key to beating the market in the long term is not beating the market in the short-term. With an upside capture of 98, these funds are not outperforming the S&P 500 in the good times. Their long-term success is defined on the downside, where they captured just 86% of the S&P 500’s losses.

Bottom Line:  

Capture ratios have two distinct advantages. First, they’re very easy to understand. If you’ve picked a relevant index (the total bond index for core bond funds, for example) and your capture ratio is 1.0 or higher, you’re doing good. Pretty much anytime, anywhere, 1.0 and up is the goal. Second, they allow you to get past the simple question “did the fund make 10%” to the more useful question, “how did the fund make 10%?”

Folks with access to MFO Premium (we offer access as a thank-you for folks who make a tax-deductible contribution at least $100 to support MFO) can run endless permutations of this same search. For other folks, we’ll continue to highlight some of the highest capture ratio funds in the months ahead.

Every strategy should be evaluated not just on a “benefit of being right”, but at least as importantly, on a “cost of being wrong”, basis…

– The Little Book of Sideways Markets, Vitaliy N. Katsenelson

I just finished The Little Book of Sideways Markets (2010) by Vitaliy N. Katsenelson. Mr. Katsenelson is a value investor, an author and CEO of a small but classy Colorado investment advisor; he offers a singularly engaging personal bio on his well-read Contrarian Edge blog. His two books cover the same ground, but are written for different audiences: professional (Active Value Investing) and lay (The Little Book of Sideways Markets). His concern here is with markets that can go up and down for 10 or 20 years and end up near where they started. In this article, I look at investing in a turbulent market which I believe will occur over the next two years using “Sideways Markets” as a guideline.

Reducing the Noise

The sheer volume and velocity of noise generated by the market and amplified by media breaks down and fatally clogs our noise-filtering mechanism. We should proactively and methodically create a proactive environment where we limit (or block outright) the majority of outside noise that comes through, and only then should we start filtering.

– Vitaliy N. Katsenelson

The economy is slow moving and, barring a catastrophic event, does not turn on a dime. Yet I constantly see in the news shows or internet that some new piece of data is described as both very positive and negative for the economy. These do have an impact on our emotions. Chart #1 shows how data can be interpreted differently. Both lines show the National Home Price Index. The blue line is the index and it shows that housing prices are climbing. The red line is the same index shown as the rate of change from a year ago. Housing prices are climbing at slower rate, as they often do before a recession.

Chart #1: Investment Model Valuation Indicator

Source: S&P Dow Jones Indices LLC, S&P/Case-Shiller U.S. National Home Price Index, retrieved Fed Rsv Bank of St. Louis; https://fred.stlouisfed.org/series/CSUSHPISA

In my opinion, a recession is not imminent, but the odds are climbing. Chart #2 shows that Total Business Sales, Orders (durable goods), Investments (Capital goods orders), Shipments, and Construction Spending are starting to contract compared to a year ago. These indices have been declining since early 2017, although Sales and Shipments are now contracting at a slower rate.

Chart #2: Contracting Economic Indicators

Source: Retrieved from FRED, Federal Reserve Bank of St. Louis

Investment Model

With so much data to absorb, I built an Investment Model using data mostly from the St. Louis Federal Reserve (FRED) database. The Investment Model was created by downloading thousands of the economic data series on the St. Louis Federal Reserve and calculating the correlation to the S&P 500 six months into the future. The ideal data should be timely, start prior to 1995, and be available on a monthly basis. Other indicators were added such as corporate, gross domestic product, valuations, investment, household, and banking because they are good long leading indicators. With 34 main indicators, no indicator has more than a few percent weighting on the overall model.

Occasionally, I read about an indicator that someone relies on and test it in the investment model. This month I added a Shipping Indicator after reading “Cass Freight Index Down 9th Month ‘Signaling Economic Contraction’” by Mike “Mish” Shedlock. Mr. Shedlock wrote:

“We know that freight flows are a leading indicator, so by definition there is a lag between what they are predicting and when the outcome is reported. Nevertheless, we see a growing risk that GDP will go negative by year’s end.”

I composited the Cass Freight Index, Value of Manufacturers’ Shipments for Manufacturing, Rail Freight Carloads, and Value of Manufacturers’ Shipments for Heavy Duty Trucks into a Shipping Indicator. Chart #3 is the Shipping Indicator compared to the average of the Chauvet Recession Probability Model and the GDP Based Recession Indicator available on the FRED database. It has a 39% correlation to the recession indicator 4 months into the future.

Chart #3: Shipping Indicator

Source: Created by the Author based on data from the St. Louis Federal Reserve (FRED)

The Investment Model maximizes return of portfolios by changing allocations to stocks and bonds based on the economy, financial markets and risk. The chart below is a bit scary, both for its complexity and for its investment implications.

Chart #4: Investment Model

Source: Created by the Author based on data from the St. Louis Federal Reserve (FRED)

Remember that my model starts with a series of economic indicators, such as the freight index. The red line is a summary of the indicators used to create the Investment Model, in particular it shows the percent of those indicators that are negative. They’re getting more negative.

The shaded areas are where I estimate it is reasonable to be more aggressive (green) or defensive (red). The solid blue line the estimated allocation to stocks.

In theory, your equity allocation should correspond to the dashed blue line. In practice, it’s neither reasonable nor practicable for investors to jump from a 140% positive leverage to a 120% net short and so, following Benjamin Graham, I cap maximum equity exposure at 75% and minimum exposure at 20%. That’s represented by the solid blue line. As of October 2019, the model portfolio would move to its most conservative allocation of 20% in equities.

Which equities? Over the remainder of this essay, I’ll try to merge Mr. Katsenelson’s observations with current economic conditions and MFO data to suggest specific portfolio positioning.

Price to Earnings Ratio

In the late stage of a secular bull market P/E stops rising. Investors receive “only” a five percent return from earnings growth-and they are disappointed. The love affair with stocks is not over, but they start diversifying into other asset classes that recently provided better returns (real estate, bonds, commodities, gold, etc.). Suddenly, stocks are not rising 12 percent a year, not even 5 percent, but closer to zero-P/E decline is wiping out any benefits from earnings growth…

– Vitaliy N. Katsenelson

As long as investors believe that lowering interest rates and continuing quantitative easing improves stability, stock prices are likely to rise. When investors are inclined to risk aversion, lowering interest rates is unlikely to prevent the price to earnings ratio from contracting. Because the economy has been slowing for close to two years, real estate and utilities have had great returns and now have higher valuations. I have sold utility and real estate funds to lock in gains as the funds become more volatile. I am concentrated in bonds, and hold more gold than usual.

Dividend Yield

• • [Dividend] yield is a function of two factors: dividend payout and stock market valuations. Dividend payout is the percentage of earnings corporate boards decide to share with investors. During the last century dividend payout was about 60 percent of earnings; however, from the mid-1990s to the mid-2000s it declined to about 30 percent as managements favored stock buybacks over dividend payments…
  • Stock buybacks can create shareholder value if the stock is purchased cheaply, but they often destroy value when management overpays for the stock.
  • An even worse reason that management is prone to overpay for company stock is that their compensation is often linked to EPS growth. And they will often do anything to stimulate that growth, even if that means destroying shareholder wealth through stock buybacks.
  • Stock buybacks when the company stock is undervalued make sense.

– Vitaliy N. Katsenelson

Chart #5 shows that share buybacks are reduced during recessions. Companies tend to pay high prices during bull markets and reduce buybacks when stocks are cheap. This is a practice that will exacerbate price declines during a down turn, because lower dividends don’t provide as much protection during the downturn.

Chart #5: Dividends vs Stock Buybacks

Source: S&P Dow Jones Indices

Table #1 shows the average performance of 400 equity funds in existence during the 2007 Bear Market by Lipper Categories separated by dividend yield. General observations are that 1) the S&P 500 and Growth Funds performed worse regardless of dividend yield, 2) large cap value performed better but still lost an over 25%, 3) Equity Income (Dividend) lost roughly 20 to 25 percent during the recessions, and 4) that higher yielding equity funds are often riskier. If an investor believes that a recession may be coming in the next year or two then it may be time to shift allocations to Equity Income and Value Funds. Two examples of top ranked funds are American Century Equity Income (TWEIX) and AMG Yacktman Focused (YAFFX), both of which are Great Owls.

Table #1: Fund Performance during Bear Markets

Created by the Author Based on Mutual Fund Observer Data

As I near retirement, I reflect on the importance of income. I divide yields by the Ulcer Index to find the best risk adjusted income. My perception is that stock buybacks have lowered dividend payouts and the decrease in stock buybacks during recessions means that smaller dividends are less incentive to own dividend equity funds during a recession. Table #2 summarizes nearly 600 funds using MFO Multisearch for funds that existed prior to the 2007 Recession and yield more than 4%. The Yield to Ulcer Index ratio measures the risk that an investor is taking for that income. Keep in mind, that the yield on municipal bonds is tax exempt. In my opinion, building a defensive income portfolio should incorporate lower risk bond funds as a priority over equity funds.

Table #2: Yield vs Risk

Created by the Author Based on Mutual Fund Observer Data

Rolling 3 Minimum Year Minimum Return vs Recovery Time

Someone recently suggested looking at returns versus recovery times. I downloaded over 700 funds that existed prior to the 2007 recession and grouped them by Lipper Category as shown in Chart #6. The blue box is the categories that I want to concentrate in prior to a recession. They have short recovery times and mostly positive gains during its worst three year rolling average.

Chart #6: Minimum 3 year Rolling Return vs Recovery Time

Source: Created by the Author based on Mutual Fund Observer

Table #3 contains most of the categories with the shortest recovery times and highest minimum rolling three year return. The Bear Column is the average return for the 2000 and 2007 bear markets.

Table #3: Lipper Categories with Short Recovery Time and High Returns (Minimum 3 Year Rolling)

Sideways Markets

Historically, stock performance has been only slightly better and sometimes marginally worse than bonds [during sideways markets]. [During] the 1966-1982 sideways market, stocks barely outperformed long-term bonds and were beaten by Treasury bills. Depending on what interest rates and inflation do over the next decade, broad market indexes may or may not be a superior investment to bonds, as P/E expansion will not be a source of stock returns.

– Vitaliy N. Katsenelson

To Mr. Katsenelson’s point, the S&P500 has returned 2.9% annualized for the past 18 months as the P/E ratio has been gradually falling from 25.5 in January 2018 to just over 22 now, a drop of 13%.

Interest rates have been falling for the past year or so and bonds funds have done well. The European Central Bank has lowered interest rates and is continuing bond purchases (quantitative easing). The Federal Reserve has lowered interest rates twice and is likely to continue as long as the economy is showing signs of slowing. Interest rates affect the price of the dollar which affects exports. The Federal Reserve is likely to continue lowering interest rates and bonds are likely to do well over the next year or so.

Don’t own stocks just to be invested. In the absence of attractive equity investments-the right stocks-fixed –income instruments (or cash) are viable alternatives to an “average” stock.

– Vitaliy N. Katsenelson

We don’t know that the economy will slip into a recession, and markets typically do well during an election year. Retirement Income, Mixed-Asset Target Allocation Conservative and Moderate funds are great choices for an uncertain time where markets may have some life left, but the risk of recession is rising.

During secular bull markets selling is frowned upon as buy-and-hold turns into investing religion… Emotions assault us from different directions when we face a sell decision: If it is a losing investment, we want to wait until we break even… Or when it comes to selling a winner, we want to sell only at the top. Again, this is the wrong attitude…

– Vitaliy N. Katsenelson

Understanding Risk

What risk means to us is shaped by our time horizon. If you are investing for the long run-at least five years-a permanent loss of capital is the risk that you that you should be concerned with the most… If you have a short-term horizon, to you volatility is not temporary. Even a temporary stock decline results in a permanent loss of capital, since you don’t have the time to wait it out… There is another important, although less tangible, issue with volatility: It impacts our emotions and makes us do the wrong things-buy high and sell low. For a very rational computer-like decision maker this is not an issue.

– Vitaliy N. Katsenelson

My risk tolerance varies with the business cycle and with approaching retirement. The Mutual Fund Observer Portfolio tool quantifies the risk in my portfolios. I use a time period that starts close to January 2018, as investors began started rotating to late stage assets. Portfolio rates most of my portfolios as Conservative (2), and provides APR Rating, Ulcer Index, and Martin Ratio. It allows me to evaluate the funds within my portfolio and alternative funds. This is particularly important for employer sponsored plans with limited fund selections.

The investing environment is infested with randomness-it is a continual professional hazard. Our skill, knowledge, and experience should help to reduce the risk of randomness, but completely eradicating it is impossible, since randomness is the nature of the investing jungle. Stay within your circle of competence and do in-depth research to decrease the amount of randomness and its impact on your portfolio… Finally, to help protect yourself from randomness-diversify.

– Vitaliy N. Katsenelson

Ranking System

While the next quote is about stocks, it is equally applicable to funds:

• • Spend more time focusing on the process than on the end results… [Randomness] is as constantly present in investing as it is in gambling.
  • Stocks should be purchased when the risk/reward equation is tilted in your favor and sold when that stops being the case. Stocks that became fairly valued, the ones that have exhausted their margins of safety and in which expected total rate of return… now fall below your expectations should be sold-period.
  • Strict sell discipline will increase portfolio turnover and replacing stocks that are on the way out with new ones will become a priority.

– Vitaliy N. Katsenelson

The MFO ratings accurately describe funds with current and historical metrics. The 3 and 10 month trends are useful for estimating which funds are peaking or starting to accelerate. The price to earnings ratio is useful for estimating which funds may be overvalued and at risk of sharper declines. Leverage and bond quality provide insight into the performance during recessions. Building a ranking system is my way of speeding up the process of consistently identifying funds based on the criteria that I believe is important if we are headed toward a recession. I use Momentum (3 and 10 month trends, Returns), Quality (bond rating, low leverage, Fund Family Rating, Ferguson Metrics, composite ratings), Valuation (price to earnings ratio, price to cash flow, price to book), Risk (Ulcer Index, MFO Risk, capture metrics, debt to equity, performance during recessions), Risk Adjusted Returns (Martin Ratio, MFO Rank, Great Owl and Honor Roll Classification), and Income (Yield).

Table #4 contains the Lipper Categories that ranked highest over the past 18 months with some adjustments. The Bear column refers to the average performance during the 2000 and 2007 bear markets.

Table #4: Top Ranked Lipper Categories

Table #5 contains the top ranked funds in the top ranked Lipper Categories. The funds are a starting point for research and not a recommended list.

Table #5: Top Ranked Funds by Lipper Category

Table #6 contains my top ranked funds. I am biased toward Fidelity and Vanguard, but include other funds for interested readers.

Table #6: October Top Ranked Funds

Closing

Following the process described in this article, I have been reducing risk in my portfolio for over a year. I am pleased with its low risk, high risk adjusted performance. I evaluate the economy each month to form an intermediate view of the economy and investment environment. I then evaluate which funds in my portfolio are “losing their margin of safety”. I limit changes to my portfolio to less than 2% of assets to avoid over-reacting and trading too often.

I appreciate the invaluable service that Mutual Fund Observer has contributed to developing a low risk, high risk adjusted portfolio. With the data from the St. Louis Federal Reserve FRED database and Mutual Fund Observer, the process takes about 2 hours per month. Researching funds and writing articles is the time consuming, but enjoyable hobby.

About a year ago we identified emerging markets value funds as one of the market’s few bright spots, at least if valuations are important. (And they are.) Since we published that story, three things occur to us.

1. Some emerging markets value funds have, indeed, done well.
2. The long-term case for emerging market value remains strong.
3. The options for prospective EM value investors have become clearer

Download a the .pdf version of this story.

The performance of EM value

There are about 40 EM value vehicles available for retail investors. Year-to-date performance ranges from 15.5% for Seafarer Overseas Value down to (1.4%) for Advisory Research Emerging Markets Opportunities (ADVMX, soon-to-be Vaughan Nelson EM Opportunities). As a group, the EM value funds and ETFs have returned about 5% YTD while EM funds overall have earned 7.8%.

The long term case for emerging market value remains strong.

Investors worry a lot about the threat posed to their portfolios by “bubbles.” The problem is that bubbles are hard to spot (everything’s a bubble when you’re panicky) and their resolution is hard to game (sometimes they simply sag, other times they persist for years). Rob Arnott and his colleagues at Research Affiliates argue that it might be more profitable to invest in “anti-bubbles.” At base, they argue that “bubbles” are marked by asset classes where every conceivable thing must go right simultaneously to justify investors’ current optimism toward them. “Anti-bubbles” are asset classes where every conceivable thing must go wrong simultaneously to justify investors’ current pessimism toward them.

American stocks, they argue, are in a bubble. Emerging markets stocks, and particularly smart beta value stocks, are in an anti-bubble. They believe that’s implausible in the short-term, and that that pessimism has driven EM valuations to historic lows.

The folks at Lazard illustrate the magnitude of the difference that investors are willing to pay for EM stocks versus stocks in the developed world or the S&P 500. At base, the discount now offered by EM stocks is far higher than it’s been in years.

Research Affiliates uses that valuation disconnect to help explain their conclusion that, over the next 10 years, EM stocks are apt to be the highest performing asset class.

GMO, whose asset class predictions tend to be pretty reliable over the long term (that is, like the rest of us they’re horrible at predicting next year but, unlike the rest of us, decent at predicting the next decade), contend that EM value stocks are the only asset class accessible to retail investors with even the prospect of double-digit returns.

The options for prospective EM value investors have become clearer

The table below represents all of the EM value funds and ETFs with a record of three or more years. While there is no formal EM value category in either Lipper or Morningstar, these funds are categorized as Emerging Markets Equities funds, and Morningstar assigns their portfolios to the “value” style box.

Using the performance of the MSCI Emerging Markets Value Index as a benchmark wherever possible, we highlight (in green) funds with superior three-year records. APR, or annual percentage return, shows the average annual returns for the funds for the three years ending 8/30/2019. Maximum drawdown and standard deviation give an indication of the funds’ riskiness. The remaining three columns offer risk-return balances.

For APR, standard deviation and Sharpe ratio, we highlighted funds that outperformed their benchmark index. For the other values, which aren’t available for the index, we highlighted the three or four top performers.

Emerging Markets Value funds, sorted by three-year Sharpe ratio

The clear winner is Seafarer Overseas Value (SFVLX/SIVLX), which led its benchmark and peer group in every single measure of return, risk, and risk-adjusted return. The fund recently passed its third anniversary and earned a four-star rating from Morningstar and a Great Owl designation from MFO. The fund has also outperformed its famous larger sibling, Seafarer Overseas Growth and Income (SFGIX). Interested readers might want to review our Elevator Talk: Paul Espinosa, Seafarer Overseas Value to get a sense of his (and Seafarer’s) approach to the asset class.

The strongest raw returns were posted by Cambria Emerging Shareholder Yield ETF (EYLD), a $28 million passive ETF which invests in 100 companies with the best combined rank for dividend payments and net stock buybacks, with an additional screen for quality and diversification. It’s a five-star fund with a pretty broadly diversified portfolio, although one might want to approach “net stock buybacks” with some caution if you’re looking for a long term metric.

The Schwab Fundamental Emerging Markets Large Company Index Fund (SFENX) tracks a different sort of index. Rather than weighting stocks on their market capitalization, they weight them on company fundamentals: sales, cash flows and dividends + buybacks. That index was constructed by Research Affiliates, the group bullish on EM value to begin with. While not a “value” index per se,  the emphasis on real companies with real profits and real dividends biases the portfolio toward value stocks.

Finally, one new option is the LSV Emerging Markets Fund (LVAZX) which launched January 17, 2019. LSV famously attempts to exploit the psychological quirks of other investors, and its principals include several renowned economists who helped found the discipline of behavioral finance. LSV has managed this strategy for more than 10 years in a series of separate accounts and European investment vehicles. Over that decade, their separate account composite, net of fees, returned 7.1%, the MSCI EM index returned 5.8% and the MSCI EM Value index made 4.6%. The performance of LSV’s other funds has been inconsistent, but it bears watching.

Bottom Line:

It’s easy to allow our short-term travails –apocalyptic headlines abound – to blind us to long-term opportunities. Indeed, asset classes become long-term opportunities precisely because so many of us become anxious and blinded. While a conservative asset allocation might make all the sense in the world just now, considering EM value for a portion of your equity allocation might well be the most profitable path you’ve got.

Fortunately, in Seafarer and a small handful of others, you’ve got better choices than every before.