Zaks Investment Advisory Service

On Stock-Picking and Efficiency of International Markets

A strong argument could be made that for an individual investor, stock picking or even funds picking is not a very effective strategy. The efficiency of the US market is such that an individual investor has a very small chance of consistently outperforming the market. It has been argued that even hedge funds do not outperform the market, if taking into account backfill bias and survivorship bias (for example, see Malkiel and Saha’s article Hedge Funds: Risk and Returns in Financial Analysts Journal.) At the same time, however, a number of analysts believe that this efficiency does not exist in some segments of the market, such as small stocks, for example. Also, it is widely assumed that international markets are much less efficient than the US’s; therefore, stock picking is a very appropriate strategy for international funds and thus warrants the high management fees that international funds usually command. Let’s examine this hypothesis.

Standard & Poor’s just released their “Index vs. Active Fund” scorecard. As usual, the majority of the domestic actively managed funds underperformed the indices. It also turns out that international indexes outperformed the majority of the actively managed funds. In the category which could potentially be most promising for active managers – emerging markets – Standard and Poor’s reported that the S&P/IFCI Composite index outperformed 75.0% of the actively managed emerging markets funds.

This result is very interesting due to the fact that emerging markets are notorious for being subject to insider trading, manipulation by the government, and general corruption. Surely, fund managers, attuned to the vagaries of the local financial climate, should be capable of beating the averages! As it turns out, this is not the case.

Let’s take Russia, for example. 2006 was a good year for Russian stocks. Fueled by high oil, gas, and metal prices, the commodity-heavy Russian stock market performed very well: the Russian Trading System (RTS) stock index gained 70.75%, going from 1125.60 to 1921.92.

Source: RTS

In light of this, how did the Russian funds perform? There are several US funds carrying Russian stocks, only two of which are “purely” Russia-oriented: ING’s Russia Fund (symbol: LETRX) and World Funds’ Third Millennium Russia Fund (TMRFX). Two closed-end funds, Central Europe and Russia Fund (CEE) and Tempelton Russia and East European Fund (TRF) have the majority of their holding in Russian companies (by the end of 2006, more than 91% of all holding of Russia and East European Fund were Russia-related.)

ING’s Russia Fund is much larger than its peers; it has $925 million under management, compared, for example, to $137 million in Third Millennium. Although it performed nicely in 2006, gaining 67.5%, the results were 3.25% lower than the 70.75% growth in the RTS index. Since the Russia Fund charges a load of 5.75%, an investor who was to buy the fund and hold it for a year would have received an actual return of 57.9% (see note at the bottom for an explanation of this calculation).

Even if the investor had already previously paid the front load, the fund still under-performed the index by 3.25% during 2006. This, however, is not the whole story: the stocks in the fund pay dividend, whereas the index only follows the price. Our best estimates indicate that the average dividend yield on the RTS index in 2006 was approximately 1% (for example, Lukoil pays 2%, Gazprom – 0.5%. The Russian Finance ministry “recommends” that 20% of net earnings be paid out as dividends. With a P/E ratio of 20 this comes to a 1% dividend yield). Thus in reality, the Russia Fund underperformed the index by 4.25%, which may partially be explained by the fund’s management fee, at about 2%.

The other of the previously mentioned “purely” Russia-oriented funds, Third Millennium Russia Fund, performed much worse. In 2006 the fund gained only 37%, just a tad higher than half of the index’s gains! It is hard to explain such poor performance. But even with such sub-par performance, the fees the fund charges are handsome: Class A shares sell with a front load of 5.75% of the offering price and the total annual operating expenses are 2.75%. Class C shares do not carry a front load but the operating expenses are 3.50%.

There are also two closed-end funds that invest mostly in Russian stocks: Central Europe and Russia Fund (CEE), which is managed by the Deutsche Bank Group and Tempelton Russia and East European Fund (TRF). The returns for the Central Europe and Russia Fund were about 40% in 2006. Approximately 55% of its holdings are Russia-based, the rest of the holdings are from Central Europe. Because Central European markets performed worse than the Russian market, it is difficult to compare the fund with the “purely” Russian funds

The Tempelton Russia and East European Fund is a very interesting story. As it is a closed-end fund, its price is determined by the market. Although its price is anchored on the Net Asset Value (NAV), the fund may trade at a premium or at a discount. This is important to keep this in mind when looking at the fund’s results. On the basis of its NAV, the fund returned 68.83%, an excellent result – kudos to Dr. Mobius, Templeton’s managing director of Emerging Markets. But in terms of market price, it performed even better: 88.7%! How did this happen? Well, at the end of 2005 the fund traded at a premium of 20%, but at the end of 2006 the premium grew to a whopping 40%. The extra 20% of the market price growth added to the 2006 results of the fund. It is not clear why the premium was so high (it went down to 20% in the first 3 weeks of 2007). Although investors cannot rely on such fluctuations, they can, nevertheless, create a very profitable bump in returns. (Just for reference, at the end of 2005 and 2006, the Central Europe and Russia Fund was trading at a discount of approximately 4-5% to NAV therefore not significantly affecting the market results of the fund).

As we can see, based on the NAV, none of the funds reached the performance level of the RTS index. It seems that even in such a notoriously inefficient market as Russia, where the notion of insider dealings does not even exist, the stock pickers didn’t fare very well. The Russian stock market is relatively small – both in terms of total market value and in the number of different securities. There are active domestic funds, which have more issues than there are stocks on the RTS. Nevertheless, the active fund managers still under-performed the index.

Where does this leave the investor? Longing for a good index fund or, even better, an exchange traded fund (ETF). Recently, iShares created the India Exchange Trade Note (ETN). Hopefully, Barcays and iShares will follow suit and create more single-country ETFs or ETNs. In the mean time, investors should be mindful of risks associated with international investing and pick their funds (or ADRs) carefully.

Note on front loads.

Mutual fund companies make front loads look smaller than they actually are. The front load is calculated off the sale, or offering, price, not Net Asset Value (NAV). For example, let’s take a fund whose NAV at the end of the year is $100. With a 5.75% front load, the fund’s price to an investor would be $106.10: the fund calculates the sale price not by adding 5.75% to the NAV, but by dividing NAV into 100%, minus the load: 100/(1-0.0575) = 106.10. We can see that 5.75% of 106.10 is $6.10, which is the amount the Fund would add to the NAV to arrive at the sale price. If the fund were to gain 67.5% (as LETRX did), at the end of the following year its NAV would be $167.5. The gain for the investor would then be 167.5/106.10 or 57.9%, which is less than 67.5 minus 5.75, or 61.75%, as one might have initially thought.