Nicholas-Applegate’s systematic team is a pioneer in the quantitative management of emerging markets portfolios. The team is applying the same philosophy and process it has used for the International Systematic strategy since 2001 and its Global Systematic strategy since 2004. At the Margin met with the Emerging Markets Systematic implementation team, which includes Kunal Ghosh, Portfolio Manager; Steven Tael, Portfolio Manager; and Sherry Zhang, Analyst, to learn more about quantitative emerging markets management and their investment outlook.

Q: What is the investment philosophy and process for Emerging Markets Systematic portfolios?
Team: The Emerging Markets Systematic strategy was developed as a natural extension of our successful International and Global Systematic strategies. We felt that the firm’s philosophy of identifying stocks we see undergoing sustainable positive change could be successfully applied to stocks in the rapidly growing emerging markets equity universe.

Q: How does your experience managing global and non-U.S. developed markets help you manage an emerging markets strategy?
Team: One advantage is that we have an existing successful international platform that we could extend to the emerging markets stock universe. While there are significant similarities between the International/Global Systematic Equity Model and the Emerging Markets Systematic Model, the models are not identical. Stocks in developed markets require slightly different model attributes than stocks in emerging markets. If the models are compared side by side, there is significant similarity. For example, when we are searching for positive change catalysts, we utilize analyst forecasts. Emerging markets can be far less efficient than developed markets; some of our technical parameters are modified to exploit this inefficiency.

The similarity between models does not end at the stock-selection level. The International Systematic, Global Systematic and Emerging Markets Systematic strategies all use a common model to measure stock-specific risk.

Lastly, as emerging market firms adopt developed market accounting standards (e.g., GAAP and IAS), we have confidence that our qualitative overlay efforts will be meaningful.

Q: How do you manage risk in the emerging markets asset class?
Team: The Global/International Systematic strategies and the Emerging Markets Systematic strategy use similar risk controls. There are still two components controlling risk. At the stock level, the risk model provides an estimate of idiosyncratic risk for each stock. At the portfolio level, risk constraints ensure that the portfolios do not differ too much from the benchmark.

The one significant difference between these strategies is that we put tighter bounds on the country exposures for the Emerging Markets Systematic strategy. Emerging market countries, as the name implies, have more sovereign and geopolitical risk than do developed markets. For example, if an emerging market country experiences a political event, all stocks in that country are affected. These tighter bounds in the strategy help control political risk.

Because we believe that the emerging markets asset class is inefficient, we relax the constraint on the active position size. This is the reason that the Emerging Markets Systematic strategy runs at a slightly higher tracking error than our Global / International Systematic strategies. We believe this to be a prudent tradeoff between seeking outperformance and controlling for risk.

Q: What challenges have you encountered?
Team: Quantitative managers are typically late to the party when it involves a new market space or geographical region. This is because quantitative managers require mounds of data in tabulated form which may not be readily available. This is what keeps most quantitative managers out of the emerging markets space. However, we realized that data are available over the last seven to ten years, but, because of the lack of scrutiny by investors, the data are not very clean. Producing clean data was our biggest challenge, but we expect our efforts will be rewarding for our investors.

Q: Where are you finding opportunities in emerging markets?
Team: We noticed the combined GDP of the twenty-five emerging markets countries in the MSCI EM Index has been ramping up and has become as large as the Eurozone Average GDP. See Exhibit 1.

Brazil is experiencing a materials boom, has increased domestic consumption and a very favorable interest rate environment. It is one of the few countries whose central bank is decreasing interest rates. Every other central bank is increasing interest rates to reduce the liquidity in the market.

China has been experiencing explosive growth for some time now. This growth is not only driven by exports, but the increasing wealth of Chinese citizens is driving growth through increased domestic consumption.

We’re finding significant opportunities not only in BRIC (Brazil, Russia, India and China), but in other countries. National economies that are favorably exposed to these larger markets will benefit, and our model reflects this. South Korea has benefited from the explosive growth in China through their shipbuilding and construction industries. China imports raw materials and exports finished goods through shipping. Shipping demand has grown tremendously in the last few years. The backlog on South Korean shipbuilders has grown up to four years. Construction companies, such as Samsung Construction, are involved in building Chinese infrastructure including refineries, toll roads, and office buildings.

Other economies enjoying growth include Taiwan and Thailand. Taiwan is the location for a significant percentage of semiconductor manufacturing. Thailand has a relatively greater degree of political instability, experiencing a political coup in September 2006. Stocks are trading at a large discount relative to other emerging market countries even as the Thai economy continues to expand.

Q: Is there steam left in Brazil and China?
Team: Yes, we are still very bullish on economic growth in China and Brazil, as the underlying economies of these countries remain healthy. While emerging markets stocks have enjoyed large gains during the past year, corrections can occur at any time, driven by events not related to stock or economic fundamentals.

Q: Are you finding companies with good underlying fundamentals?
Team: Our model is revealing opportunities in a variety of areas, such as Taiwanese semiconductor firms, Korean construction firms, Chinese refineries and South African banks. South African banks are benefiting because the South African banking system is on a par with the developed world and is active throughout Africa. This is typical: as these societies become wealthier, they start to demand different kinds of goods and services reflecting the greater wealth of their societies.

Q: Thank you for your time. Good luck with the new strategy.