Targeting alpha in Asian equities

Key points

• Asian markets can often be overlooked and under researched by Western investors – but the region offers substantial potential
• And while the region’s dynamics can be complex, having good local knowledge can help to extract above-market (or alpha) returns from these fast-growing markets 
• Importantly, investing in Asia doesn’t have to be all about focusing on high-growth and highly speculative companies
• Strategies that can neutralise market risk, while exploiting Asia Pacific alpha opportunities, can help to improve portfolio diversification

Fighting the home bias

As discussed in Overcoming home bias when investing, too much exposure to local financial markets can hurt portfolio returns. Yet, investors are often uncomfortable investing in markets that feel foreign to them. 

More recently, we’ve seen increasing interest in emerging market equities and bonds, driven by the view that the global hiking cycle in interest rates is coming to an end. Yet, Asian equity markets remain underrepresented in many investors’ portfolios, especially in Europe and the US.

For some investors, it's easy to justify avoiding investing in a region. First and foremost, Asia is physically (and often culturally) distant from the West and corporate governance is frequently seen as weak. Second, recent geopolitical tensions (around Taiwan in particular) have dented investors’ appetite. Third, policies, whether their regulatory, monetary or fiscal, appear somewhat disconnected from what is happening in the rest of the world. 

Yet, the Asia Pacific region represents 44% of global economic growth and has accounted for 62% of global GDP growth in the last 10 years¹.

It’s not the growth story it used to be

But things are changing fast in the most populous region on the globe. China used to be the growth engine of the world, providing cheap labour and a fast-expanding supply of workers. But the Chinese population is now ageing at warp speed and fertility rates are expected to fall (see chart). The proportion of the country’s population that is over 60 years old is projected to reach 28% by 2040². 

Similarly, South Asia has between 10% and 18% of its gross domestic product (GDP) at risk due to climate change, claimed the World Economic Forum last year³. This is roughly treble the economic growth at risk as that of North America, and 10-times more than the least-affected region, Europe.

Given potential changes to Asian growth and population dynamics in coming decades, the way to invest in the region ought to change. Buying and holding exposure to the area because of its economic prospects is a strategy of the past. That being said, it remains a very fertile hunting ground for those that know where to look. 

Less equity research means more opportunities

One reason why it can be easier to find investing opportunities in Asian equities is that there is limited coverage of them by Wall Street investment banks, reducing the volume of work that needs to be sifted through. The median stock in the S&P 500 is covered by 22 sell-side analysts, according to Bloomberg data. In the MSCI Asia Pacific, which consists of 1,488 stocks, the median number of analysts following a given company is 15.  

More importantly, around 13% of the companies included in the MSCI Asia Pacific index are covered by five or less analysts. In the US, this number is 1%. In other words, there are a lot fewer eyes scrutinising Asian companies’ performance.

In order to generate performance in excess of their benchmark (known as “alpha”), fund managers and stock pickers need an edge. They need to identify trends and data points that are unknown to their majority of investors.  

This can be achieved much more easily, and consistently, in less-covered markets. Of course, alpha generation is not guaranteed. But the likelihood of being able to create it is, statistically speaking, greater in Asia than say when investing in US large-cap stocks.

Local knowledge is paramount 

Local knowledge of a region can also help to navigate what some would think of as unorthodox policies. 

Here, Japan springs to mind. Indeed, the country seems to be operating in a world of its own with a debt-to-GDP ratio of 226% and a central bank that effectively controls the yield curve and owns three-quarters of the country’s exchange-traded funds. While many may see this context as a clear “no-go” when it comes to local investments, it can also represent a great opportunity for those who understand the Japanese model.  

In fact, this opportunity may be even more relevant at this point in time. Indeed, with Japanese headline inflation at 3.2% in March⁴, it is widely expected that the central bank will be forced to abandon, or at least tweak, its yield-curve-control (YCC) policy when it next meets, in mid-June. This momentous change in policy could open the door to a new era when it comes to investing in Japanese assets.

Mitigating risks 

Unfortunately, understanding the far-reaching implications of scrapping YCC in Japan or the various policies announced by the Chinese authorities this year is complicated. This is especially the case in today’s markets, which often seem to surprise investors with their reaction to events. 

This is why, when investing in Asia, it is important to focus on finding opportunities to boost returns rather than purely gaining exposure to the market. In other words, focus on the alpha and not the beta.  

In addition, neutralising market risk allows portfolio performance to capture the skill of investment professionals more cleanly, while avoiding being wrong-footed if markets react unexpectedly to economic data.

Investing in Asia need not just be about trying to “blow the lights out” through a focus on high-growth, highly-speculative companies in that part of the world. Instead, adding market-neutral exposure to the region can help to further diversify portfolios. In doing so, it can help enhance returns, especially in terms of predictability and without compromising the risk budget.