August 2010; market overview

August brought with it a sell off for risk assets that served to erase much of July’s gains. Data remains a key driving force for markets at the moment, with each new print providing a slightly different steer in an uncertain world. It seems as if market participants are, on the whole, low in conviction and therefore any potential guidance is seized upon with vigour. It may seem hackneyed to speak of the human emotional element in the markets, especially as in recent months much has been made of the potential market impact of computerised trading (High Frequency Trading has been linked to the ‘flash crash’ of May 6th when the Dow fell 1000 points in 20 minutes) but it is clear that far from being cast aside and confined to the annuls of history, the driving force of sentiment is ever present and will remain an important factor in driving the markets for the foreseeable future. Our view remains constructive on equity valuations over the long term, but recently markets have been lacking direction; indeed we noted in July’s Viewpoint that “July’s rally might prove a little too sharp”.

The markets have not decided whether they are in the double dip camp or the slow growth camp and therefore any apparent consensus must be treated with care. Figure 1 below shows that the percentage of ‘neutral’ respondents to the American Association of Individual Investors (AAII) survey has drifted up since 2007, meanwhile the bullish sentiment present earlier in the year seems to have abated somewhat of late. Short term market volatility, which is often the consequence of changes in sentiment, provides opportunity for valuation driven investors. Whilst equities retraced, throughout August government bonds regained their momentum and the US 10 year yield finished the month yielding 2.47%, which is just above the levels seen in August 2008 (see fig 2 below).

fig.1 Source: MIC/Bloomberg

Turning to the markets, barring a couple of positive spikes, the trend for most of the month was negative. The MSCI world ended August -3.7% lower in US dollar terms. Year to date the index is -6.2% below 2009’s close as the markets have been blustered by a combination of positive news from corporations and generally poor news from global governments (especially within the developed world). Prospects for the (developed world) consumer continue to look reasonably bleak and this is one major mitigating factor in an otherwise constructive corporate picture. In August the emerging markets proved more resilient when compared to their developed counterparts. This is a positive sign as it is suggestive that the markets, however fickle, remain somewhat focused on fundamentals. The global emerging markets should provide a higher potential risk and reward trade-off but the ability of the GEM markets to fair better in the face of selling pressure in the developed world shows that the market is not making a careless intellectual leap from weak growth in the developed world to inevitably spoiled growth in the emerging markets. Despite continued strong trade links between the old world consumer and the new world industrial powerhouses, it is clear that internal demand in the latter region should at least provide a prop for local companies in the event of a slump in demand within the developed markets.

Within the fixed income markets, government paper again benefitted from a flight to quality as investors sold equities and looked for lower risk assets in which to invest. The global government bond index gained 2.1% for the month in US dollar terms, bringing the year to date gains to 6.0%. Investment grade debt failed to fully participate in this rally and as a result broader bond indices such as the Citigroup WorldBIG index gained 1.4%. Year to date, this index has also lagged the pure sovereign play, with returns of 3.8%. We remain of the view that government paper does not offer attractive value at present levels.

From a nominal perspective the yield available on the US 10 year bond, for example, is at a level last seen in late 2008 and early 2009, in the teeth of the global liquidity crisis. Although conditions are difficult at present, it does seem that pricing a bond at levels close to the post-Lehman fallout seems difficult to justify. Although nominal bond yields are interesting, their levels are affected by extraneous factors such as inflation. When the influence of expected inflation is stripped out, as in Fig 2, the picture remains the same. The real yield is in fact as low as it was in February 2008. Even more interesting still is the fact that the real yield has drifted down since the beginning of the graph. Over this time, not only has the nominal yield dropped, but also the after expected inflation yield required from bonds by the market has also fallen.

fig.2 Source: MIC/Bloomberg

The listed property sector did not provide positive returns in August, however they succeeded in outperforming the broader global equity markets despite the present concern regarding the strength of GDP growth globally. The global property securities market returned -0.9% in US dollar terms and the US and UK both posted negative returns in local currency terms of -1.3% and -0.8% respectively. Europe and Asia were stronger gaining 0.9% and 0.6% in their respective local currencies. Year to date the returns differentials between the regions is highlighted by the 13.7% gain in the US compared to 1.6% in US dollar terms for the global index.

The US dollar benefitted from the risk aversion trade, gaining against most majors. The one exception was the gain on the Japanese yen against the greenback, adding 3.2% over the month, to bring the year to date gain to 10.9%. The strength of the US dollar against other majors will have provided a tailwind to performance of non-US assets when reported in US dollar terms.

The commodity markets are a regular feature in headlines at the moment as supply and demand imbalances have led to significant price increases for certain pockets of the market. This is reminiscent of the food supply related social unrest seen in 2007 and 2008 and indeed in August Mozambique has seen rioting and multiple deaths in the streets of Maputo due to food price increases. Overall returns from commodities have been mixed year to date and it is only specific futures prices that have grabbed attention. Agricultural commodities have outperformed the broader commodity index on both a one month and a year to date basis. The broad commodities index returned -2.8% despite a strong return from gold of 6.6%, likely on the back of the risk aversion trades seen throughout the month. Agricultural commodity futures have posted gains of 2.0% in August and 2.7% year to date in US Dollar terms.

Focus: Small really is beautiful

This research note was written, and has been reproduced with the permission of, Firth Investment Management.
The basic premise of this Research Note is that investors should actively consider a portfolio allocation to Asia (ex- Japan) small cap stocks. There are three main elements to this premise, and we provide important evidence in support of each.

1. The “alpha” argument

In an investment world in which excess returns appear increasingly elusive, we see significant potential for the generation of alpha within an allocation to Asian small cap. A key plank of this argument is the simple fact that many of the companies and listed securities in this segment of the market are not extensively covered by financial analysts. As a case in point - consider Chart 1 on the right, which shows the strong growth in the number of listed companies in Asia, but a rather more meagre increase in the number of analysts covering these stocks.

Chart 1
Stock in Asia ex-Japan with market cap < US$1 bn.
There are c.12,000 such companies, of which only 24% have analyst coverage.

In recent years, many academic studies have investigated the link between levels of analytical (or media) coverage and stock performance. Some² have shown that low levels of coverage are consistent with subsequent outperformance by the stocks in question. Other studies³ have looked at the flip side of the same coin, and have shown that excessive coverage can result in overvalued stocks. Either way, the appeal of under-analysed stocks is clear, and the relative performance to be unlocked upon initiation of broader analytical coverage can be significant. As stocks receive greater attention, not only may their market valuations rise, but they may also enjoy more liquid trading conditions⁴, narrower bid-ask spreads and a reduction in the random variation of their prices⁵, all of which should be good news for the small cap manager who has taken an early exposure to these stocks.

Chart 2
Number of analyst submitting Year 1 EPS forecasts.

Source:I/B/E/S; Thomson Reuters Datastream; VaR

These arguments are perhaps more widely discussed and understood in the mature stock markets of the West, but we think they are highly relevant to Asia. We have investigated the linkages between coverage and stock market valuations in Asia, and have found a positive - and statistically significant - relationship. In Chart 2 we show a scatter diagram linking the market valuation of companies in Asia with the number of relevant earnings forecasts being produced by analysts. We have added a line of best fit to highlight the positive relationship - the greater the analytical coverage, typically the higher the market valuation (relative to a company’s book value).

Of course, it’s one thing to recognise that a small Asian company is poorly-researched, but quite another to work out whether that company is worth investing in, which brings us neatly to the second strand of this alpha argument. Low analytical coverage will mean that there are many undiscovered gems around corporate Asia, and the investors with the greatest chance of unearthing these opportunities will be those who have, or who can tap into, a strong local presence in the region. That on-the-ground analysts might enjoy some sort of informational advantage over those without a local presence seems a fairly intuitive point, but it is one which is again supported by a considerable body of academic work⁶ (and not often highlighted by managers of Asian small cap portfolios who are based somewhere other than in Asia!).

2. The expected return and diversification argument

In an investment world in which excess returns appear increasingly elusive, we see significant potential for the generation of alpha within an allocation to Asian small cap. A key plank of this argument is the simple fact that many of the companies and listed securities in this segment of the market are not extensively covered by financial analysts. As a case in point - consider Chart 1 on the right, which shows the strong growth in the number of listed companies in Asia, but a rather more meagre increase in the number of analysts covering these stocks.

Using actual historical monthly returns for a number of main asset classes⁷, we derive a long run covariance matrix (Table 1 below contains the base data) and use this to develop a set of implied asset class returns. To this base case, we then apply our own views on asset class returns over the next 2 years, with associated confidence levels. This combination of historical covariances and risk-adjusted return forecasts enables us to produce a set of long run expected returns (Table 2 below).

Source (both tables): Citigroup, MSCI; Thomson Reuters Datastream

From these expected returns, using classic Markowitz-style mean-variance analysis, we build a series of efficient frontiers for a range of investor types. Finally, we arrive at the whole point of this exercise - we are then able to assess the impact on each of these risk/return profiles of introducing an allocation to Asian small cap equities. We consider this from the perspective of five different investor types or portfolio structures: Global Balanced, Global Equity, Global Small Cap, Asian Balanced (ex-Japan) and Asian Equity (again, ex-Japan).

In all five cases, the addition of an exposure to Asian small caps either significantly expands the range of risk/return possibilities (thanks mainly to higher expected returns from Asian small caps), or results in significant rotation of the efficient frontier (upwards and to the left), or both.

We illustrate this by looking at the first of our portfolio/investor types - Global Balanced. Our research shows that, for a global balanced portfolio with a 6% expected return, the unconstrained inclusion of Asian small caps lowers the expected risk (standard deviation of returns) by 460 basis points.

Looked at slightly differently, if we target risk at the level of this 6% return portfolio including Asian small caps, then the removal of Asian small caps from the portfolio mix reduces expected annual returns by 110 basis points. This analysis is illustrated graphically at the top of the next page, in Charts 3 and 4

The results are similar for each of the other four portfolio/investor types, and are available on request. In summary, the risk and return characteristics of the various asset classes are such that the portfolio optimiser will always select the maximum possible exposure to Asian small cap, whatever the portfolio type.

In the unconstrained optimisations, this means that Asian small cap will typically dominate the portfolio structure. In the case of Global Balanced which we looked at above, Asian small cap effectively replaces global equity in the portfolio mix along most of the efficient frontier.

In the case of a Global Equity portfolio, at all levels of risk, the counterweight to cash in the mix is an allocation to Asian small cap at the expense of an allocation to Global Equity. Similarly, in the case of a Global Small Cap portfolio, “cash plus Asian small cap” is preferred to “cash plus Global Small Cap” and in both the Asian Balanced and Asian Equity portfolios, Asian small cap takes the place of Asian Large Cap throughout the entirety of the efficient frontier.

We recognise that investors are highly unlikely to assume the levels of exposure to Asian small cap implied by this optimisation process. But that is not the point of this exercise. The critical message from our analysis is that a reasonable set of return expectations will result in a disciplined asset allocation process opting to hold Asian small caps up to the maximum level allowed, within the broader constraints imposed by the investor’s risk appetite.

In the above analysis, we examined the impact on risk and return expectations of adding an exposure to Asian small cap to a broad portfolio mix. Many international investors have already accepted the merits of including Asian equities in their diversified portfolios, typically via an exposure to Asian large cap stocks.

As an alternative to this approach, we argue that these investors should actively consider an allocation to Asian small caps. We base our case on the analysis of some pertinent data presented at the top of the next page, which this time covers the 10 years ended September 2009, so includes the impact of market movements in the wake of the global financial crisis.

In Table 3 we can see that, over the 10 year period through September 2009, average (i.e. mean) monthly Asian small cap returns exceeded the equivalent returns from Asian large cap. There is an even more significant difference between small and large cap when we look at the median returns over the same period. This is a result of more frequent months of positive returns from small cap, and of larger average small cap monthly returns when returns are positive. The ratio of average returns to standard deviation of those returns implies a positive trade-off for investors prepared to switch from large cap to small.

In the second half of Table 3, we show the correlations between various international asset classes and, respectively, Asian small cap and Asian large cap equities, again over the 10-year period to September 2009. The correlations between the international assets and Asian small cap are consistently lower than the equivalent large cap statistics. Global, US and European equity investors could gain a greater degree of portfolio diversification by taking an exposure to Asian small cap, rather than Asian large cap.

3. The fat tails argument

We are particularly interested in the characteristics of the “tails” of the return distributions for Asian small cap and Asian large cap equities. Our analysis has produced two important findings. (Again, we are looking at 10 years of data through September 2009.)

First, the returns from both small and large cap equities in Asia are not normally distributed. Investors who assume normal distributions are likely to be underestimating so-called “tail risk”, particularly the risk of larger-than-expected negative outcomes.

Second, and relatedly, if we apply empirical techniques to fit non-normal distribution curves to both small cap and large cap monthly return data, we find that the negative tails (i.e. the probability of a monthly return being below the median return) are similar for both small and large caps, but that the positive tails (the probability of a monthly return being above the median) are significantly “fatter” for small cap than for large cap. This is illustrated in Chart 5.

The implication of this work is clear - downside risk (relative to average returns) in Asian equity is similar in small and large cap stocks, but upside opportunity (again relative to those average returns) is greater in small cap than in large cap.

Summary and conclusion

We have presented evidence in support of three important elements of the case for investing in small cap equities in Asia. The alpha argument is essentially that Asian small cap stocks are generally poorly-researched. This presents significant opportunities for on-the-ground analysts to uncover undervalued stocks, but we also point to the prospects of a “re-rating” of many of these stocks, based solely on the impact of increased analytical coverage over time.

The expected return and diversification argument has two strands to it. The first is an absolute argument - that the addition of an Asian small cap exposure to a wide range of multi-asset portfolios has the potential to improve the overall risk and return characteristics of those portfolios. The second is a relative argument - that the risk and return characteristics of Asian small cap, and the correlation between Asian small cap and other international equity classes, when compared to the equivalent statistics for Asian large cap, point to small cap being the more efficient and effective way to take portfolio exposure to Asian equity.

Finally, still looking at the merits of Asian small cap relative to large cap, the fat tails argument holds that, while downside risk (relative to average returns) is similar in both small and large stocks, upside opportunity (again relative to those average returns) is greater in small cap than in large cap.

We argue that international investors, who have not yet included an exposure to Asian small cap in their diversified portfolios, should now take a close look at the attractions of this under-appreciated segment of the international investment market.

Notes

1 Throughout this Note, reference to Asian small cap stocks should be taken to mean “Asia, ex-Japan”
2 Hong, Lim & Stein (2000) - Journal of Finance Volume 55, Number 1, et al
3 Douglas, Kim & Pantzalis (2005) - Financial Management, Volume 34, Number 2, et al
4 Irvine (2003) - Journal of Corporate Finance, Volume 9
5 Schutte & Unlu (2009) - Financial Analysts Journal, Volume 65, Number 3
6 Bae, Stultz & Tan (2008) - Journal of Financial Economics, Volume 88, et al
7 We use monthly total returns for the 10 year period from October 1998 to September 2008

Disclaimer This report is for informational purposes only and in no way constitutes the provision of financial advice, nor the does the report represent an offer or solicitation with respect to the purchase or sale of any security. Although the statements of fact in this report have been obtained from and are based upon sources that Firth Investment Management Pte Limited believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions and estimates included in this report constitute Firth Investment Management Pte Limited‘s judgment as of the date of this report and are subject to change without notice. Firth Investment Management Pte Limited does not accept any responsibility and cannot be held reliable for any person’s use of or reliance on the information and opinions contained herein. Firth Investment Management Pte Limited, its directors, employees, their families and other related groups and individuals may at any time hold positions in financial securities mentioned in this report.

RECENT MANAGER MEETINGS

RECENT MANAGER MEETINGS

ALLIANCE BERNSTEIN INVESTMENT MANAGEMENT
Tim Banks has moved to AllianceBernstein as Head of Defined Contribution Sales, reporting to UK & Ireland Sales Manager, Simon King. Banks was formerly at Prudential, where he was Director of Business Development, responsible for the UK distribution of DC, investment platform and de-risking products. Before that he held senior positions at Fidelity, Standard Life and Towers Watson, where he specialised in employee benefits and investments - performing a range of sales, consultancy and business leadership roles.

CORNELIAN ASSET MANAGERS
June Jessop has left Cornelian Asset Managers, where she was Head of Charities. In the interim, Investment Director, Marcus Brooks and Stephen Hunter, Director of Private Clients and Charities, will take over responsibility for the firm's charity clients. Jessops future destination is not yet known.

FIRST STATE INVESTMENTS
Gregor Kurth has moved to First State Investments as a Fund Manager. He was formerly at Deutsche Infrastruktur.
Inderdip Syan has moved to First State Investments as a Fund Manager. He was formerly at Rutley Capital Partners.
Raphael Viallet has moved to First State Investments as a Fund Manager. He was formerly at 3i Infrastructure.

FRONTIER CAPITAL
Nahed Ennasr has moved to Frontier Capital Management as a Senior Analyst. He was formerly at Caisse de depot et placement du Quebec.

GLG PARTNERS
Mark Diab has moved to GLG Partners as a Portfolio Manager. He will take on responsibility for Middle East and North Afrian Equities within the GLG Emerging Markets team, reporting to Bart Turtelboom and Karim Abdel-Motaal, GLG's Co-Heads of Emerging Markets. Diab was formerly at AMWAL, Qatari Investment Bank, where he was a Managing Director responsible for its Equity Asset Management division

HERMES INVESTMENT MANAGEMENT
Chris Taylor has moved to Hermes Real Estate Investment Management as Chief Executive. He joins the fund manager's GBP 5.8bn Property arm. He was formerly at QIC, Australian-based global fund manager, where he was Head of European Property. Before that he was at HSBC Specialist Investments as Director - Head of European Property. Prior to that he worked in Property Fund Management at Prudential UK.

HSBC ALTERNATIVE INVESTMENT
Amy McNally has moved to HSBC Alternative Investments as Global Marketing Manager reporting to Florence Picon. She was formerly at Barclays Wealth where she was a Product Specialist covering alternative investments. Her role involved the marketing and distribution of Hedge Funds, Private Equity and Real Estate products both in the UK and across EMEA. Before that she was at JP Morgan Treasury Services on the Sales and Distribution side. Prior to that she started her career in ABN AMRO Mellon working in their European Sales team.

INSPARO ASSET MANAGEMENT
Graham Stock has moved to Insparo Asset Management as Chief Strategist. He was formerly an Emerging Markets Fund Manager at JP Morgan, where he was in charge of CEEMEA FX strategy, as well as investment decisions for the Latin American Sovereign market.

JP MORGAN ASSET MANAGEMENT
Neil Gregson has moved to JP Morgan Asset Management as a Global Equity Fund Manager. He will join JP Morgan's funds arm, which houses one of the best-regarded natural resources teams in Europe, led by Specialist Fund Manager, Ian Henderson. He was formerly at CQS Asset Management where he was Head of Equities. Before that he was at Credit Suisse Asset Management, where he specialised in natural resources funds, including gold portfolios.

KITE LAKE CAPITAL MANAGEMENT
Massi Khadjenouri has founded Kite Lake Capital Management. She has teamed up with Jan Lernout, a former Senior Partner at Cheyne. They are preparing to launch a special situations Hedge Fund, a strategy which exploits distressed stocks, mergers, takeovers and other big issues. Khadjenouri was formerly a founding Partner of Centaurus Capital. Before that she was at Cheyne.

LEGAL & GENERAL INVESTMENT MANAGEMENT
Ian Simpson has moved to Legal & General Investment Management as an LDI Account Manager. He will be responsible for the service provided to LDI clients. He was formerly at BlackRock Investment Management.
Michael Walsh has moved to Legal & General Investment Management as an LDI Product Specialist and will provide support to both the marketing and client liaison teams. He was formerly at BlackRock Investment Management.
Shajahan Alam has moved to Legal & General Investment Management as a Senior Structurer. He will design and implement derivative-led solutions for clients. He was formerly at Towers Watson.

LOMBARD ODIER
Richard Walsh has moved to Lombard Odier as Head of Emerging Market Debt. He was formerly at BlueCrest Capital Management.

MARTIN CURRIE
Darius Sliwinski has left Martin Currie, where he was an Emerging Markets Fund Manager. Sliwinski, who runs the firm's Emerging Markets Oeic, will leave the firm on 10 September. His future destination is not yet known

MATRIX GROUP
Alkesh Chohan has moved to Matrix Group as an Analyst in its Fund of Hedge Funds group. He will further strengthen the five-strong Fund of Funds team at Matrix and will be responsible for conducting thorough due diligence on prospective managers and developing existing relationships with fund managers and prime brokers. He was formerly at TCP Asset Management, where he worked as an Investment Analyst.

PIMCO EUROPE
Julien Wochenmarkt has moved to PIMCO Europe as an Account Manager based in London. He was formerly at Barclays.
Leo Niers has moved to PIMCO Europe as an Account Associate based in London. He was formerly at FactSet.
Patrick Dunnewolt has moved to PIMCO Europe as Head of Business Development for the Benelux region. He will report to Joe McDevitt, Head of PIMCO's London office. He was formerly a Business Development Manager at Mn Services in the Netherlands.

PINEBRIDGE INVESTMENTS
Lord Davies has moved to Pinebridge Investments as Non-Executive Chairman. He was formerly Minister of State for Trade, Investment and Small Business in the UK Government, appointed jointly to the Department for Business, Innovation and Skills and the Foreign and Commonwealth office. Before that he served as both Chairman and group Chief Executive of Standard Chartered Bank.

RAB CAPITAL
Stephen Couttie has left RAB Capital, where he was Chief Executive Officer. Couttie is to be replaced by Charles Kirwan-Taylor, RAB's Chief Investment Officer and Head of Risk. His future destination is not yet known.

ROBECO ASSET MANAGEMENT
Torben Dunkel has moved to Robeco Asset Management Deutschland as a Director of Asset Management responsible for Institutional business, looking after German Versorgungswerke, Pensionskassen and contractual trust arrangements. He was formerly a Director at Selinus Capital. He started his career as a Graduate at JP Morgan and worked in Institutional Sales at JP Morgan Asset Management.

SCHRODER INVESTMENT MANAGEMENT
Christopher McGolpin has moved to Schroder Investment Management as Head of Client Service and Business Management in its Institutional business. He will oversee the fund manager's 25-strong Institutional Client Service team. McGolpin will report to Head of UK Institutional, Miles O'Connor. He was formerly at KPMG, where he was an Associate Director. Before that, he was at Shell where he worked in Global Strategy.
Mark Brandreth has moved to Schroder Investment Management as Co-Head of Research of the Quantitative Equity products Global Equities team. He joined the QEP team, which manages in excess of GBP 10bn and will be based in London. He was formerly at BlackRock where he was a Managing Director in scientific active Equities. Before that he was at Barclays Global Investors.

SYZ & CO ASSET MANAGEMENT
Patrick Bedat has moved to Syz Asset Management as Chief Executive of its Institutional Asset Management division. He will take up his position on 13 September and will be in charge of managing the expansion of thegroup's entire Institutional Asset Management business. He was formerly at Banque Bonhote & Cie in Neuchatel. Before that he was at Pictet Asset Management as an Operating Manager.

T ROWE PRICE INTERNATIONAL
Thomas Berglund has moved to T Rowe Price as a Senior Business Development Executive with responsibility for clients in Finland and Sweden. He was formerly at Threadneedle Asset Management, where he was Director of Institutional Asset Management and Head of Nordic Distribution.

Important Notes

Disclaimer:
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