In 2010 life was hard for emerging market dividend fund managers: nobody was interested. Investors still expected ‘shoot the lights out’ capital returns from emerging markets. But by the end of 2011 emerging market dividend funds were popular all of a sudden: they all managed to outperform the MSCI emerging market equity index.
Life was easy for dividend fund managers. It was so easy that an increasing number of ETF managers have entered the ‘asset class’. One was launched on 1 July 2013 billing itself “the first Dividend Growth ETF for emerging markets”. After all, if dividend paying stocks generally outperform (as all the historical data suggests), how hard is it really to pull together a basket of dividend paying stocks that will outperform? And why not just buy an emerging market dividend index fund?
If only life were simple! Now that there are a number of emerging market dividend indices and ETFs it is easier to see how different they are from each other and how subjective all investing is. For example, compare the WisdomTree Emerging Markets Dividend Total Return Index, the S&P Emerging Markets Dividend Opportunities Index and the classic MSCI Emerging Market ‘Benchmark’ Index. Year to date in USD terms, the WisdomTree EM dividend Index is down only 7 per cent, the MSCI EM Benchmark is down 9.5 per cent, but the S&P EM Dividend Opportunities Index is down 12.7 per cent – 3 per cent worse than the standard benchmark and 5 per cent worse than a competing index.
It is one of the most commonly held assumptions in investment circles that dividend investing is more defensive than normal investing, but clearly the S&P Index providers have proved that life is not simple.
What is going on here? This might help explain. Interestingly WisdomTree actually have two emerging market dividend indices: the WisdomTree Emerging Markets Dividend Total Return Index and the WisdomTree Emerging Markets Equity Income Total Return Index. This begins to provide part of the answer, because the WisdomTree Emerging Markets Dividend Total Return Index tries to measure the performance of all dividend paying stocks in emerging markets, whereas the Equity Income Index tries to measure the performance of the highest dividend yielding stocks in the index.
And the difference in results? The Equity Income (High Yield) Index is actually down 10 per cent in USD terms, or down 3 per cent more than the index of all dividend stocks and a little more than the MSCI EM Benchmark. This result flags two things: 1) at a guess the S&P EM Dividend Opportunities Index probably has a higher yielding focus, and 2) Higher yielding dividend stocks may not in fact be more defensive. Point 2) is important because often one of the justifications trotted out for dividend yield investing is that higher yielding stocks are more defensive. This is something I have always maintained is wrong: it depends on the circumstances.
Can I explain why the S&P EM Dividend Index is still worse than the WisdomTree EM ‘High Yield’ Index year to date? Perhaps I could offer a definitive answer if I did more research into what the S&P Index providers are trying to index and how that differs from WisdomTree. But I would like to leave that to diligent readers: the most important point in this article is that investors should always try to understand the reasoning behind what they are investing in, and not invest based on the headline.
Another two points: 1) ‘Dividend Style’ investing encompasses a number of different varieties and results can vary very significantly, and 2) all indices and ETFs are also different, even if they follow the same strategy in theory (whether this is Dividend, Growth, Small Cap or Merger Arbitrage). Is your chosen index equally weighted or market cap weighted? Is it rebalanced monthly or yearly? When investing in a fund, it is always important to try to find out as much as possible about the processes of the fund manager and who they are. It tends to be assumed that this only applies to active managers, but this applies equally to passive managers because all managers and indices have their biases.
The more you understand about a strategy, active or passive, the better your relationship with the fund. This means the fewer unexplainable surprises there should be and the more likely you are to continue with a good strategy through a bad patch, which is vital for good long term results. As it turns out the S&P EM Dividend Opportunities ETF year to date is actually performing far worse that its own index and the MSCI EM Benchmark. But without more understanding of it, I would not hasten to judge whether there are not good reasons for this and indeed whether this might not be the very best time to be adding to this strategy. I simply don’t know.
Something I do know is that a successful strategy or asset class will always breed its own corruption because it becomes easy to market. Frauds and bad IPOs are bred in bull markets and discovered in bear markets. Participants in the 1990s tech bubble or the 2000s US listed Chinese stock mania know this.
The ‘dividend’ asset class, whether in developed markets or emerging markets will be no different. If dividends and dividend funds are very popular, managers of listed companies will try to boost their dividends even when they should not, in order to boost their share price. The principle is related to Batesian mimicry in biology. It is already happening for dividends. Gazprom, the Russian oil giant announced a dividend policy a year and a half ago to boost its image with investors but the dividend does not transform the corporate governance and they have already failed to deliver on announced plans, no doubt because of capex constraints. Chinese banks also pay dividends, but come back for equity capital every three years. If you invest in dividend funds, there is always the risk that your passive manager will not discriminate and your active manager will fail to notice. Should I speculate? Probably not, but forms of dividend mimicry may be one of the pitfalls the S&P EM Dividend ETF Strategy has been caught by this year – or maybe not.
In contrast to a dividend ETF strategy, which must look at the dividend as a cause of performance, the approach some active managers take (myself included) is the opposite: we look on the dividend as the symptom of good company performance: the company’s management and the strength of its business model is the cause.
For the Somerset Emerging Market Dividend Growth fund, in a sense the dividend is the last thing we look at, not the first. (Some astute investors have therefore pointed out that perhaps strictly speaking it is not a dividend fund but a cashflow conscious growth fund with a dividend derivative; I cannot say I totally disagree). There are risks to this too. As a general rule, the more active a manager the more idiosyncratic; the more passive the more consistent: there problems and risks with both. A good actively managing fund often only overlaps with the index for 5-10 per cent of the portfolio. If you measure risk in terms of opportunity cost the risk is always extremely high. For the sake of argument, despite being an emerging market fund, the fund I run would likely perform very badly if hard commodity prices were to surge.
Finally I should say that ETFs are great tools. I use them in my own personal investing. But before you use a chainsaw, you should read the instructions; and before you use a fund manager you should see how it thinks.
Edward Lam is manager of the Somerset Emerging Markets Dividend Growth fund