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By Ashley Redmond and Patricia Oey | 06-12-2013 12:00 AM

Index fund not your best bet for emerging markets exposure

Morningstar's Patty Oey takes a look overseas

This interview was conducted on June 13 at the Morningstar Investment Conference in Chicago.

Ashley Redmond: I’m here with Patty, and we just covered the International Opportunities session, and it was really interesting. The panellists got into a bunch of debates, but one thing that’s really stood out to me today [is that in] every session that I’ve attended they’ve been talking about Japan. So, in the International Opportunities session, one panellist just said, basically Japan is going to go bankrupt and he will not invest in them. Then the other panellist said that the stock is so cheap there that he has to invest in them because the prices are good.

So Patty, what’s your take on Japan right now? Are you bullish or bearish?

Patricia Oey: Okay. Well, I just want to start by saying that the funny thing is the Japan bull, what he actually said, is that he doesn’t like to travel to Japan because he says whenever he travels to Japan he meets the companies and he actually wants to sell them because he gets very frustrated talking to management.

From my point of view, I’m kind of a Japanese bear. We’ve seen the markets rally very strongly at the beginning of the year because of aggressive monetary easing, but the big challenge ahead is actually to implement structural reforms which Japan hasn’t been able to do. So, what you see in Japan is that they have very strong cultural traditions, and as a result, the labour market is actually quite rigid. So, they have lifetime employment, they have a focus on seniority, and when you have that combined with slow domestic growth, there is actually not a lot of jobs for young people.

So, what you have is that young people end up having these temporary jobs. The number of temporary workers in Japan keeps growing, and when you do have temporary workers, they don’t earn as much. They don’t have a chance to develop their skills. You have this plus a rapidly aging country and high debt levels at the government level; I think, this doesn’t paint a very good macro picture.

Redmond: Okay, and what’s your take on China? I know they were talking about a few of the problems there.

Oey: In China, I’m more optimistic about China, like I’m optimistic that generally we will see positive change. The government will be able to sort of guide the economy to move away from infrastructure-led growth to domestic consumption-led growth. The thing is that actually for investors, it’s very hard for investors to capitalize on those trends. Like when you go to China, you can feel that China is a country on the move, but in terms of like what companies to buy to be able to enjoy that growth, it’s very difficult.

A lot of the large companies in China, they’re actually government-owned, and when they’re government-owned, they’re not so focused on profitability. So, those are not the best companies. Generally in Asia, we would probably say going with an active manager is good. We really like the Matthews Asia fund family, and they have a number of regional funds, they have a number of single country funds, so I advise investors to look at that family for exposure to those regions.

Redmond: Okay. As an investor, when you’re investing in emerging markets, we tend to like certain index funds, like MSCI Emerging Markets Index, so what’s the problem with that?

Oey: Well, I generally don’t like using index funds for emerging markets exposure. In Canada and the U.S., usually the largest companies are actually very well run, profitable firms. And so, an index fund, a cap-weighted index fund, a cheap one, is good for that asset class. Whereas in emerging markets, as I mentioned before, a lot of the large caps are government-owned and actually a lot of them are also very tied to the commodity space. There are a lot of miners. There are a lot of technology companies that kind of manufacture semiconductors and things like that, and those kind of companies they’re susceptible to global growth trends, and so now that we have the global economy not growing very quickly, it’s negatively impacting the emerging market stocks.

It doesn’t mean that emerging markets are not growing quickly; it’s just that these companies are more exposed to global macro trends. So, again I think maybe active management may be a better option in emerging markets.

Redmond: Okay, great. And during the International Opportunities session, Rajiv really stood out, and I know he won Manager of the Year in 2012 for International Equity. So, just wanted, if you had some words on *Rajiv?

Oey: I thought he was great. I thought he gave – he is very good about explaining his kind of world view and then you kind of understand how his world view kind of informs his investment decisions. I also want to point out that his fund is called Virtus International Opportunity something or Emerging Market Opportunities and when you go to his website, he has this quarterly manager newsletter, and you go there and it just has a lot of details. A lot of fund companies they have their quarterly newsletter and it’s just like performance data and it’s very boring. But actually he goes into a deep analysis of – like I think the last one is about the Chinese banking system and the Chinese financial system, and how it’s very fragile and that’s why he doesn’t invest in China. It’s a great read.

And so I think seeing that, he gives you great confidence in the manager and makes you want to invest with that manager. So, I just wanted to give him a little plug.

Redmond: Great. Thanks so much, Patty. To get more coverage of the Morningstar Investment Conference, go to www.morningstar.com or www.morningstar.ca.

*Rajiv is referring to Rajiv Jain, Virtus Investment Partners

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