Asia’s Malaise Raises a Few Doubts About Index Idea
The Vanguard Group’s noble experiment in emerging stock markets has bogged down, at least temporarily, somewhere in the Malaysian jungles.
Vanguard offers the only index mutual fund that invests in developing nations. The approach had been a profitable one from the fund’s inception in April 1994 through last year, with the Vanguard Emerging Markets Portfolio among the sector’s top performers.
But so far in 1997, the Vanguard fund has been slumping, primarily because of troubles in Malaysia and other Southeast Asian stock markets. For January through August, the fund was off 3.4%, reports Morningstar Inc., the Chicago-based research group. That contrasts with a rise of 11.1% for the typical emerging- markets fund.
“Our shortfall against our competitors is owed in part to our relatively heavy stake in Malaysia, [with] about 13% of the portfolio’s assets,” wrote Vanguard Senior Chairman John Bogle and President and Chairman John Brennan in a midyear report to shareholders.
Subsequent market weakness has cut Malaysia’s weighting to about 11%, but that’s still above the 4% stake typical of emerging- market funds, says Morningstar.
Actually, says portfolio manager Gus Sauter, other Asian markets also have been hit hard by currency devaluations, slow economic growth and other problems. “Our fund is more heavily weighted in the area than traditionally managed funds,” he says.
The troubles incurred by the Vanguard fund raise the question of whether indexing is prudent for stock markets in developing nations.
An index fund invests in the same stocks contained in a certain market measure, whereas other funds have the investment decisions made by an active manager. The Vanguard fund is tied to an index that was created for it by Morgan Stanley Capital International.
The risk in index funds is that they must hold those stocks in the same proportion they are in the index. So if a portfolio has a large stake in a slumping market such as Malaysia--down more than 40% in U.S. dollar terms this year--the fund and its shareholders are caught in the storm. There’s no opportunity to respond by switching assets into other countries or into cash--options that actively managed funds enjoy.
“We want to identify and buy growth companies that are adapting to and benefiting from change,” says Pedro Marcal, senior manager of the Nicholas-Applegate Emerging Countries Portfolio in San Diego. “Emerging markets by definition are undergoing the most change, yet index funds are the antithesis of that.”
The Nicholas-Applegate portfolio, one of the top emerging-markets funds, currently has no investments in Malaysia and a scant 4% in neighboring Indonesia, Thailand and the Philippines combined. “We can’t find a single company in Malaysia that we want to own,” Marcal says.
Gerardo Espinoza, co-manager of the John Hancock Global and International funds in Boston, agrees that active management makes more sense in developing nations, with the Malaysian situation representing a prime example why.
The Hancock funds were under-weighted in Malaysia earlier this year, before Thailand devalued its currency, setting off a domino effect throughout the region.
But after Malaysia’s prime minister accused Western investors of destabilizing the nation’s economy through currency speculation and briefly placed certain restrictions on removing capital from the country, Hancock’s managers sold their remaining holdings.
“The government still thinks the country will have high GDP growth, but the depreciating currency and increasing interest rates will have a negative impact on corporate earnings,” Espinoza says.
The Hancock funds don’t have any Malaysian investments now and probably won’t add any in the near future, he says.
The lack of flexibility inherent in index funds has also caused Vanguard’s portfolio to miss out on some of this year’s hottest investments in Russia and India. A dozen nations are represented in the index that the Vanguard fund tracks, but Russia and India are not among them.
The fund targets emerging markets with relatively low trading costs and favorable policies toward shareholders.
“In Russia and India, there are still major trading and back-office problems,” Sauter says. He says the fund will soon add Poland, Hungary and the Czech Republic to its mix.
Sauter doesn’t think the fund’s troubles undermine the indexing concept. The lower costs typical of index funds give the Vanguard portfolio an advantage that normally will offset its lack of flexibility, he says. Vanguard’s shareholders pay just 0.55% a year in expenses. That’s well below the 2.52% average for emerging-market funds, says Morningstar.
Plus, trading costs such as brokerage commissions and bid-asked spreads don’t show up in such expense numbers, yet these transaction costs are exceptionally high in emerging stock markets. Since the Vanguard fund as an index portfolio does little trading, its natural cost advantage is even wider than the above figures would imply.
In short, the turmoil in Southeast Asia may have given indexing a black eye, but it’s too early to conclude that the approach has been permanently damaged.
“This is one of the classic bumps in the road that you experience with emerging markets,” Sauter says. “‘We don’t think the whole region is going to unravel.”
The cost structure of the fund discourages short-term trading. Vanguard imposes a “transaction fee” equal to 1.5% of an investor’s purchase; the amount will be lowered to 1% starting Nov. 3. Unlike loads, which are used to compensate a broker for selling a mutual fund, this transaction fee is retained by the fund to cover the costs of purchasing foreign stocks, thereby lowering ongoing shareholder-borne costs.
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Russ Wiles is a mutual fund columnist for The Times. He can be reached at russ.wiles@pni.com
