Q:  How emerging markets are different from the developed economies? A : The two general characteristics of these economies are they are growing much faster than the economies of the developed world and they have much stronger balance sheets. Historically, the growth differential has been about 3.5% between emerging and developed. That stronger GDP growth generally leads to stronger earnings growth and stronger stock market returns. Since the Asian crisis in 1998, even allowing for the last couple of years of underperformance, emerging markets are up over 500% whereas the U.S. is up 130%, Japan 85%, and Europe 120%. That is from the end of August 1998 to September this year. The result of the financial crisis has been to highlight the differences even more. What you have in developed economies are very poor demographics, aging populations; Japan is the first among developed nations with a shrinking population. The emerging markets demographics, on the other hand, are very strong. You have large, growing and young population. The other legacy from the financial crisis is massive debt overhanging in the developed world. Today, the emerging markets account for 65% to 70% of global economic growth. Emerging economies are the engines of growth in the global economy and this will continue into the future. This has been emphasized even more over the last 15 to 20 years by the arrival of 2.5 billion people in India and China starting to get wealthier and consuming more. That has changed the dynamics of the global economy. Q:  How is your approach to investing in emerging markets different from your peers? A : One of the differences between us, and our competition, is that most emerging markets managers would describe themselves as bottom up managers. They will be looking at the world of emerging markets to find 50 or 60 stocks around the world, that they think look attractive and are going to perform. We take what we call a balanced approach. We look at both country selection and stock selection for our returns. We aim to get 50% of our value from country selection and 50% from stock selection. We do not just concentrate on finding good stocks. The reason for that is in the world of emerging markets, between 50% and 70% of the returns in the past have come from getting the country allocation decision right. Therefore it seems odd to ignore country selection in managing an emerging market fund. For country selection we use a quantitative model, but for stock selection it is good old-fashioned fundamental research. The second significant difference to the competition is our attitude to risk. We believe that our primary task is to achieve return. That is no different to anyone else, but we believe that we should achieve that return with the lowest risk possible. We make an assumption that our investors are rational and logical. If you are a rational investor you should prefer any given level of return that has less risk rather than more risk. This very proactive approach to risk is quite different. For example, we set out what our return target is. We aim to outperform the index by 350 basis points over rolling three years. The reason we do that is because that is the amount of alpha we have to put on the table to ensure we give our investors a strong, competitive position. We reviewed historic returns tables going back over 20 years and found that in emerging markets you need to outperform by that much to ensure strong, competitive success. If you achieve 3.5% growth over rolling three years then 94% of the time you are in the top half of the tables and you are never in the bottom quarter. Once we have our performance target we can work out our risk budget of around 4.5% to 5%. Having the budget, which we allocate between country risk and stock risk, we do two other important things. We know, with absolute certainty that every one of our fund managers will underperform. The only uncertainty is how long the underperformance will last and how bad will it be? You cannot actively manage money without having periods of underperformance. Once you acknowledge that, it leads to very clear behaviors. Firstly, each of our managers, for their portion of the fund, has a risk budget. If they are underperforming we reduce the risk in that country. If they are outperforming, we increase the risk. This is different behavior to how managers generally work. Usually if they are underperforming they do more of the same to try and chase it, but we admit we are not right all the time. Where we are getting it wrong we will reduce the risk, where we are getting it right we will increase the risk. It is a very simple idea. The second aspect of risk control is at the stock level, where we do not allow managers to fall in love with stocks. Typically when fund managers have bought a stock, they hate to admit they got the stock wrong. We take the embarrassment out of being wrong; if a stock underperforms by 15% relative to the local market from purchase, they have got to sell the stock. Many of our competition, if a stock is underperforming, they will tend to buy more of it. They have to buy more because if they were to sell a stock they just bought a few weeks later with no news, their boss will ask them what they are doing and where is their conviction. We just accept we cannot be right all the time. Q:  How is your investment team organized and where are they located? A : The final difference regarding how we differ in the structure of our fund is we have a very strong team culture and team approach. We are as far from the cult of the individual as you can get. We have a large team of 37 people, consisting of both fund managers and analysts. The fund managers are centralized in London. We believe, to be stronger you want your managers sitting one place. This facilitates communication and exchange of ideas. On the other hand we have analysts around the world throughout Asia, Latin America, the Middle East, and Europe, close to the stocks we are investing in. Every member of the team has input in every portfolio. Our clients are not relying on just being allocated one particular fund manager. Q:  How do you incentivize your managers and analysts? A : We also have a very comprehensive assessment system. In many organizations analysts are paid on the basis of their recommendations. Fund managers are paid on the performance of the portfolios. That sounds logical but in our opinion it is wrong. We think that if all you do is pay analysts on the quality of their recommendations—are the buys up and are the sells down—then the analysts are not interested in how well the underlying portfolio is doing. They might not even know which of their stocks are going into the portfolio. We think that is a terrible way of doing it. Only 40% of our analysts’ bonus is based on their recommendations, the rest is based on the underlying portfolio performance. For example, our Brazilian analyst is going to need the Brazilian portfolio to do well to maximize his bonus. If the fund manager is not reflecting his ideas properly the onus is on the analyst to bang the table as it is going to show because it will hit their pockets. We also have a very comprehensive process. The full process description is over 100 pages long. Elements of the process go back over 30 years. It is one of the most disciplined and systematic processes around. One of the things I challenge investors who learn the process for the first time is whether they can ask a question which is not covered in the process description book. We tell them that if they do then within 24 to 48 hours there will be a new page in the book to answer it. Our strategy meetings, which are held monthly, are open to our clients. Consultants and institutional clients can sit in and attend the meeting. They can see how the process works and hear our views on markets. Q:  What is your investment philosophy? A : We believe that active management is the way to go in emerging markets. The stock markets tend to be inefficient and therefore there is a strong potential for adding alpha through active fund managers. We believe country selection is a useful source of alpha and we do not rely solely on stock selection. We do not have a systematic style bias. We are style agnostic and the reason for that is in the world of emerging, where you have over 20 countries at different stages of economic development, different parts in the cycle, for us to say that one style fits all for all those countries at all times, we think is inappropriate. We think as active managers our job is not just to manage for return but also to manage for risk. Finally, it is our strong team culture. We do not rely on just one or two individuals who are particularly talented. It is everybody involved in the decision making process. Q:  What is your investment strategy and process? A : Our first job is to decide which countries we are investing in, how much do we overweight, which ones do we underweight when measured to our benchmark? To do that we use a quantitative model that I brought into Schroders nine years ago. It has been refined and fine-tuned since then and the model itself is not a trading model, it is a fundamental model. The weights and the factors do not change too much over time. The model is relative to MSCI benchmark. We review that model every three to four years. The model itself, which we run once a month, tells us which countries to overweight and which to underweight. We then have a monthly meeting where we ask whether there is any good reason not to do what the model is suggesting. Every member of our team attends the meeting, Asia, Latin America, and the Middle East phone in and in helping to decide whether we should override the model we have various judgment inputs, such as politics and events that are not easily quantified. Each member of the team has to not only attend the meeting, but they also have to participate. We even have a methodology for ensuring they participate and if they do not participate in the meeting their bonus is reduced. It is a very lively, active debate. At the end of the meeting we all have a final decision on country allocation. Our job then is to find the best stocks in each of the countries to invest in. This is one of the areas where we differ from our competition insofar as our analysts are almost entirely organized by country rather than sector. If you are making a decision that you want X% in Mexico, you want to know which are the best stocks in Mexico to buy. If what you have is a Latin American banks analyst, or a Latin American retail analyst, that is not going to help you in deciding which Mexican stocks are the best. Although there are two elements of what we do, country and stock allocation, whereas many of our competitors are purely stock focused, that does not mean that we are short changing our stock research. We have 37 people on the team, we have analysts around the world, and our stock to analyst ratio is eleven-to-one, better than most of our pure bottom up competitors. Our analysts are organized from a country perspective, so our analyst in Mexico, for example, is ranking at least 70% to 75% of the stocks in Mexico. He is telling us stocks that are buys and stocks that are sells. Once we have allocated to Mexico, the fund manager immediately knows from the analyst in Mexico which stocks to buy and which stocks to avoid. We detail ongoing coverage of at least 70% of the stocks in every single emerging market at all times. Even in countries which we do not own, we will have up-to-date views and models of 70% of the stocks in that country, because next month we might allocate and we need to know which stocks to buy. Once we have allocated to a country the particular fund manager will look at the analyst recommendations in that country. We rate the stocks from one to four. One is a strong buy and four is strong sell. The fund manager is assessed on how well their individual country stocks perform and also partly how the portfolio overall performs. They apply the risk controls and make sure each country is inside the risk budget. Q:  What is your research process and how do you look for opportunities? A : The analysts are organized by country and their responsibility, within the country, is to cover at least 70% to 75% of the stocks in the MSCI Index. This means they need to be seeing the company and doing a full model on that stock. We have what we call “the GRID”, the Global Research Investment Database, which is used by all analysts inside Schroders. It includes a discounted cash flow based modeling tool. The analyst goes into that model, puts the data and their assumptions in, and they come up with a fair value target price for that stock. Analysts also put in details of meetings with the company, assessments of management, ESG related information and some of the qualitative aspects of the assessment. Finally, they rank the stock as a one, two, three, or four. One is strong outperformance, two is modest outperformance, three is modest underperformance, and four means strong underperformance. They do that for 75% of stocks in every market irrespective of whether we are investing or not. We expect live up-to-date models and coverage of all of those stocks at all times throughout the year. We put a couple of extra parameters on the analysts because I have learned that if you leave investment analysts to their own devices they will give you a very high percentage of hold and neutral recommendations. Analysts tend to stick to the middle, which is no good for portfolio construction. So what we do in each country is to tell them that they have to give us at least 30% of their recommendations as outright ones and 30% as outright fours. They cannot have more than 40% in the two and three category. Because this is a relative ranking, even if they think the market is going to drop 50%, if they have a stock that is only going to drop 10%, that is a clear one rank stock. Once we have allocated to a country we always have access to strong buy ideas inside that country. Then we have three global emerging managers that divide the world up equally between them, having six to seven countries each. They will then construct their respective country portfolios looking at the profiles and rankings coming through from the analysts and buy ones and twos and avoid threes and fours inside each country, always keeping inside the risk control. Even though we have such emphasis on risk control, typically 90% of our portfolios are in stocks ranked one or two. We do not have to buy too many stocks we do not like to achieve the risk controls that we have. A typical portfolio will have about 120 stocks in it, whereas our bottom up competitors will probably have 60 or 70. Even 120 are still quite concentrated relative to the index, which are about 800 stocks. In terms of the analysts ranking stocks, they use the Discounted Cash Flow model along with other metric to come up with a fair value assessment; they will not have a systematic style bias. We are not imposing a growth or value type approach on all of our analysts. We are giving them the freedom to operate within each individual market with what they think is appropriate. Q:  What is your portfolio construction process? A : Our country allocation comes out of the monthly strategy meeting and the model. Once we decide to allocate to a particular country, the three global fund manages divide the total market cap between them. They then construct the country portfolios using the rankings from the analysts. He will buy ones and twos, avoid threes and fours, always keeping inside the risk parameters. Our turnover is quite low. Over the last few years the total turnover in the portfolio, which is country turnover and stock turnover, has been around 50% to 60%. We tend to take a 12 to 18 month view of the stocks they are investing in. The only people that benefit from high turnover are the brokers taking commission—we want to keep our turnover low. We do not look at sector allocation as a source of alpha. We do have a separate monthly sector meeting so we will take the position on countries, then we look for the best stocks in each country and that gives us our portfolio of 120 or so stocks. We then look at the portfolio from a sectorial point of view and ask whether or not it makes sense given our global economic view. We also have a sector model and we look for how we are different from the sector model, but that is just as a sense check. It is not as a source of alpha. We believe that in emerging markets the country selection decision is much more important than sector decision. The only exception would be commodities. Q:  How do you define and manage risk? A : The top level of risk for our flagship, Global Emerging Market Fund, its task is to beat the index. We are looking at the tracking error and containing that relative to the benchmark because our investors are looking for us to beat that index. Our investors are deciding whether we are doing a good or bad job dependent on our ability to beat the index. The reality is that underneath that there are many risks. There could be political, currency, and economic risks and all of that goes on as part of the assessment of the individual countries. That is why even though the model is a prime guide for country allocation; we still need to apply some judgment. For example, last year our model wanted us to be overweight Egypt. Of course the model did not understand revolution and change of government and people dying on the streets, but we hopefully did understand that. One of the other tenets of controlling risk is diversification, which is why we would never suggest to an investor that they go just for one country. If you do that you are taking onboard a lot of extra specific risk, which you do not need to do. For example, you can reduce political risk significantly by having a diversified approach. By investing in 25 or so countries, by not putting all your eggs in one basket, that helps reduce the impact of some of those specific risks or concerns you may have in a particular country. Currency is also part of the judgment override. If we have got worries about a particular currency we will not do a separate hedge, we will simply reduce the exposure to that country. The reason we need a team of 37 people and the analysts around the world is so that we are close to these countries and hopefully we can understand the local dynamics and the local issues and risks very well, rather than just having a small team based in London and New York. You cannot cover the world without having people on the ground understanding the local environment. Q:  How emerging markets have evolved in the last two decades from an investing perspective? A : The changes in emerging markets over the last 15 or 20 years have been very positive. For example, when I first started managing emerging markets 35 years ago, you had to accept that they were relatively risky. Investors certainly required a risk premium to put their money in emerging. If you look back at the history of Latin America, hyperinflation, currency devaluations, et cetera—there have been a lot of problems—so investors needed a lot of risk premium to go in. But what has happened over the last 15 or 20 years, which was really emphasized with the 2008 financial markets crash that originated in the U.S., is that emerging market fundamentals have improved dramatically. To the point where I can say today that emerging markets’ economic fundamentals are now stronger than the developed world. Whether you are looking at the fiscal position, current account, level of inflation, economic growth, and level of reserves, on any measure emerging is stronger than developed. That is a huge change. Simply looking at economic risk today, investors should ask for a risk premium when they invest in the U.S. or Europe or Japan, relative to emerging. That is a massive shift in mindset. I will accept that the political risks in some of these countries can be higher, although one has to say with the shutdown in Washington at the moment, there is political risk in developed countries too. But the way to reduce that in emerging is through diversification across the range of countries. I think that going forward you are likely to see emerging markets trade fairly consistently at a premium to the developed world.