Conventional wisdom dictates that a higher dispersion of returns create more “alpha” opportunities for active managers. (It does not, however, guarantee it!) In this bulletin, we take a closer look at recent trends in return dispersion across both countries and sectors for the Asia ex-Japan equity market, as well as where the potential “alpha” opportunities lie.
• We find that return dispersion across both countries and sectors has been rising, and expect this to continue. As central banks move toward monetary normalisation, the “rising tide of quantitative easing (QE) liquidity that has lifted all boats” will start to fade. This makes the case for active investing and tactical asset allocation (TAA) more compelling.
• Sector return dispersion levels have risen close to those of country return dispersion levels. We believe that this is likely in part due to the growing market cap of the information technology (IT) sector in China, Korea and Taiwan, which has resulted in a significant overlap between the respective country and sector returns. Therefore, active asset allocators may want to pay closer attention to sector investing.
• On a country level, the dispersion of returns is higher in China, Korea and Taiwan, and lower in Singapore and Malaysia. On a sector level, the dispersion of returns is higher in IT, health care and consumer discretionary, and lower in financials. Not surprisingly, more “alpha” opportunities lie in the “micro-driven” sectors with high firm-specific risk, as opposed to “macro-driven” sectors with low firm-specific risk, and we see merit in stock pickers diverting more resources to these areas.
WHAT IS DRIVING RETURNS IN ASIA EX-JAPAN-COUNTRY OR SECTOR?
Asia ex-Japan equities have posted a stellar performance year-to-date (up 31% in U.S. dollar terms and 25% in local currency terms as of end-September). However, we find that market breadth has been rather narrow. Breaking the performance down by country, we find that most of the returns can be attributed to a few countries, with China, Hong Kong and Korea contributing 72% of the total return. Similarly, breaking performance down by sector, we find that most of the returns can be attributed to a few sectors, with IT, financials, real estate and consumer discretionary contributing 81% of the total return. See Exhibit 1A and Exhibit 1B on the next page.
Sector allocation is becoming more important in driving equity returns
This raises the question: does country or sector allocation matter more? To shed more light on this, in Exhibit 2 to the right, we calculated the cross-sectional dispersion (standard deviation) of returns across countries and sectors, respectively, for Asia ex-Japan equities. In general, we would expect that the higher (lower) the dispersion of returns, then the larger (smaller) the “alpha” opportunity set available to active asset allocators, and therefore the higher (lower) the potential for outperformance (underperformance) versus the benchmark. If the dispersion of returns across countries is higher than the dispersion of returns across sectors, then it supports the case of country allocation versus sector allocation, and vice versa.
First of all, we find that the return dispersion across both countries and sectors in Asia ex-Japan equities has risen this year, with country dispersion slightly ahead (albeit dispersion levels are still relatively low when compared to pre-Global Financial Crisis levels). We argue that with central banks now moving toward monetary normalization, the “QE liquidity put” is being gradually removed. This should push return dispersion levels higher, with investors having to refocus back on growth fundamentals. In other words, we see more “alpha” opportunities arising for active managers, which strengthens the case for active investing and TAA.
Second, we highlight that sector return dispersion levels have risen close to country dispersion levels in Asia ex-Japan equities. This suggests that more “alpha” opportunities are arising for active managers that engage in sector allocation versus country allocation. Given that many traditional asset allocators still manage Asia ex-Japan equity portfolios on a country basis, it may make sense for them to start looking at sector investing as well.
We point out that the closing sector/country return dispersion gap could be in part attributable to the growing market cap of the IT sector. As shown in Exhibit 3 on the next page, the IT sector weight in the MSCI Asia ex-Japan equity index has increased from 20% in December 2007 to 32% in September 2017. IT now makes up 40% of MSCI China, 48% of MSCI Korea and 64% of MSCI Taiwan, therefore creating a significant overlap between the respective country and sector returns. Asset allocators running overweight (underweight) positions in China IT, Korea IT and Taiwan IT this year would have more likely than not strongly outperformed (underperformed) their benchmark.
Looking for potential “alpha” opportunities Taking a step further to see where potential “alpha” opportunities lie for active stock pickers, we calculate the return dispersion (standard deviation) within each country and sector, respectively, for Asia ex-Japan equities. See Exhibit 4 and Exhibit 5 on the right.
On a country level, we find that China, Korea and Taiwan have the highest return dispersion, while Singapore and Malaysia have the lowest return dispersion. On a sector level, we find that IT, health care and consumer discretionary have the highest return dispersion, while financials has the lowest return dispersion. It should be noted that there are some notable overlaps in country and sector. As mentioned earlier, China, Korea and Taiwan have relatively large IT sector weights, while Singapore and Malaysia have relatively large financial sector weights.
These findings make intuitive sense. IT, health care and consumer discretionary sectors are what we can characterize as “micro-driven” sectors with high firm-specific risks driving a higher dispersion of returns. By searching for “alpha” opportunities in these sectors, active stock pickers will be disproportionately rewarded if they manage to identify the big winners – whether it be the next technology disruptor, the new blockbuster drug and/or the latest hot-selling consumer product.
Conversely, the financials sector is what we can characterize as a “macro-driven” sector with low firm-specific risk driving a lower dispersion of returns. With banks being levered to the business cycle and the current “low interest rate” environment being a key driver of profits, it is more challenging for stock pickers to differentiate themselves on the basis of their bottom-up stock-selection ability.
A stronger case for active investment and tactical asset allocation: We argue that as monetary policy normalizes and the “QE liquidity put” is withdrawn, dispersion of returns will continue to rise as investors refocus back on growth fundamentals. This will, in turn, create more “alpha” opportunities for active managers, which supports the case for investing in traditional, actively managed mutual funds versus exchange-traded funds. Of course, return dispersion is a necessary, but not sufficient, condition for manager outperformance. Only skilled active managers will be able to successfully capitalize on these “alpha opportunities” and add value via making the right country and sector allocation calls.
Pay more attention to sector allocation: Sector dispersion of returns is rising and closing the gap with country dispersion of returns. This is likely in part due to the growing IT sector market cap weighting in the Asia ex-Japan equity index. As getting the sector allocation call right is becoming almost as important as getting the country allocation call right, active asset allocators may want to also focus on sector investing.
Where to find “alpha” opportunities: Active stock pickers should devote more efforts to looking for “alpha” in countries like China, Korea and Taiwan and “micro-driven” sectors such as IT, health care and consumer discretionary with high firm-specific risk, as these are the areas where their hard work and skill would pay off best.
By J.P.Morgan Asset Management
Author: Jasslyn Yeo. PhD, CFA, CFTe. Global Market Strategist
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