Quants eye emerging markets

It's much cheaper for quant firms to launch emerging markets strategies because traditional firms need to employ large teams of analysts. "If you're going to be implementing a new emerging markets strategy, if you don't have the analysts in place, it's easier to do with a quant strategy," said John Wasnock, director of manager research at Wurts & Associates, Seattle, an investment management consulting firm.

However, Scott Whalen, a senior consultant in Wurts' Los Angeles office, questioned whether emerging market stocks will continue at their fevered pace.

"The frightening part is that returns have been driven by surging commodities prices," he said. "My question is, ‘Is this a short-lived thing or are emerging markets coming into their own?'"

That unknown aside, some experts said the importance of stock picking in generating alpha from developing markets has soared.

"It used to be a country selection game completely — call it 10 years ago — and now we're seeing a significant shift toward stock selection," said Churchill Franklin, executive vice president at Acadian Asset Management Inc., a Boston-based quant shop.

Acadian closed its emerging market stock strategy to new business at $5 billion at year-end 2004, just 16 months after it had been launched. The firm uses both active stock and country selection.

Money managers said the quality of data for emerging markets companies has improved dramatically in recent years.

Five years ago, only about 30% of Eastern European companies met international or U.S. accounting standards. Now, about 75% do, said Thomas Mead, managing director of the Barr Rosenberg Research Center at AXA Rosenberg. Mr. Mead said the firm has been investing in Asian stocks for some time, but a move into South American and Eastern European stocks is new.

Mr. Mead said data available from vendors has improved. "We're able to get the detail in emerging markets from about 4,000 companies," he said. "We need excruciating detail from the companies we invest in."

Bob Jones, managing director at GSAM, said his firm has "spent a lot of time getting the data clean enough." He said GSAM officials expect to roll out a quantitative emerging markets strategy that uses stock selection in the third or fourth quarter, although they might add stock picking to existing global equity strategies sooner. Currently, GSAM uses a passive approach to picking stocks.

Other managers said poor data quality has not hindered them from profiting from stock selection in emerging markets.

John Chisholm, executive vice president and co-chief investment officer at Acadian, said the firm invested a lot of effort to scrub data. That gave Acadian an advantage over other managers, he said.

Echoed Arjun Divecha, portfolio manager at Grantham, Mayo, Van Otterloo & Co. LLC, Boston: "The worse the data, the bigger the opportunity." GMO manages about $20 billion in emerging markets equity strategies; it closed its core product in September 2003.

Unlike most firms, AXA Rosenberg remains neutral on country bets. "We're not taking bets or positions on countries," Mr. Mead said.

Nor does LSV Asset Management, Chicago. LSV, which began investing in emerging markets July 1, already runs some $400 million in the strategy and has $350 million in additional commitments. The strategy is capped at $1 billion because it invests in all capitalizations, while most emerging markets products focus on large-cap stocks, said Christopher LaCroix, partner.

Many quant firms, however, use some combination of country and stock selection. Besides Acadian and GMO, State Street Global Advisors, Boston, runs $7 billion in active quant strategies in global, regional and single-country mandates, while Arrowstreet Capital LP, Cambridge, Mass., manages more than $1.4 billion in dedicated emerging markets equities.

Meanwhile, Robert Arnott, chairman of Research Affiliates, said his firm is several weeks away from seeding an emerging markets strategy based on the firm's fundamental indexation approach.

Results from back-testing show that fundamental indexation would have chalked up 10 percentage points a year in added value over the FTSE All-World Emerging Markets benchmark from 1994 through 2005.

That figure, however, is based on local currencies and has not yet been converted to U.S. dollar terms. The back-testing used an equally weighted universe, rebalanced annually, using company fundamentals of free cash flow, book equity value, total sales and gross dividends.

Mr. Arnott expects FTSE Group will license the emerging markets index within a year. FTSE already offers the fundamental indexes for domestic and developed markets.

Eventually, Research Affiliates plans to launch an enhanced version of its emerging markets index. "We find these (fundamental) indexes beat cap-weighting by a large margin, and yet these indexes are not hard to beat themselves," Mr. Arnott said.