Originally published at 8020investors.com

In this article, I have summed up the essence of 80/20 investing. It all leads back to operating from a position of financial strength and making the right decisions. Through some core rules of intelligent investing, you can find out the quickest and least risky way to wealth that will set you on the path of becoming an 80/20 Investor.

#1 80/20 Investing is about doing your homework

There are a couple of tasks you need to do to make the right financial decisions for yourself. You can read up on these simple tasks in any self-help book on home budgeting and financial management, but here are the basics:

Take an inventory of all your assets. Assessing your earning power and taking an inventory of all your personal assets is vital when it comes to investing.

You won’t be able to avoid unnecessary risk, if you are not sure about your income situation and the financial reserves you have at your disposal. The old adage “nothing ventured, nothing gained” may be true, but doesn’t imply that you should be taking dumb risks.

Get your financial house in order by measuring and assessing it. Periodically go over these numbers. It will train you to take charge of your financial affairs, which is, ultimately, the single most important step in creating an investment plan.

Check your current and potential earning power, and keep track of expenses. Equally important is the matter of saving to accumulate assets and to build a strong financial base for future investing.

Saving works! If there is not enough money for future financial needs such as retirement, you either save more money, work more, work longer, or you create additional earnings opportunities over time, so that you can save more in the future.

Once you have done your homework, you can start contemplating on index fund investing, crypto coins or any other esoteric asset classes in more detail. It starts with the all-important question: how much money are you willing to lose?

#2 Before you invest in other people’s businesses, open a business

Warren Buffett, with his usual sagacity, once said, “I am a better investor, because I am a businessman, and a better businessman because I am an investor.”

If you study Warren Buffett’s early life, you will see how he started out by delivering newspapers, then investing his savings in a pinball machine and a beaten down Rolls Royce that he rented out. He even bought farmland.

He created his own business platform based on income-producing assets that would finance all his future endeavors. He admitted that his early experiences of going into his own business taught him valuable lessons for his future career in money management and stock market investing.

Before you even consider buying other people’s assets, create your own assets, like Buffett did. Invest in yourself or create a business from scratch. By far the most important income-producing asset will be yourself. Get an education, training and work experience — it will be the best investment you can ever make.

Needless to say, you need to monetize skills and passions. Today, with the diversity of digital platforms, and the reach of the digital world, anyone can bootstrap simple income-producing assets. Your first platform might not turn a profit quickly, but managed well, it will never financially bankrupt you.

It would also teach you valuable lessons about business investing, and that can be projected onto financial markets. You would learn the basic concepts of economics firsthand — input and output, as well price determination depending on demand and supply.

You would learn the impact of economic cycles in your own business, and how to make it less prone to downturns. You would truly understand the magic of compounding returns that so many financial gurus rave about.

You’d experience a crash course in basic accounting and budgeting where you will see money going out, but, initially, little coming in.

Automatically, you would learn to control your spending — a vital skill for financial success. You would also understand the difference between real cash flows (i.e. cash hitting your bank accounts vs accounting earnings).

You would also learn everything about modern marketing and promotional techniques in order to generate sales — how to encourage potential customers to open their wallets for you- from limited time offers to buy one get one free or those dreaded pressure-sales techniques expedia.com is famous for (’50 customers have booked this hotel in the last hour!’).

At the very least, you will become aware of these elaborate techniques when they’re used on you.

#3 Always assess the odds of success or keep your wallet zipped

Having gone through your personal MBA course, and having your own income-producing assets, you will know how difficult it is to establish and maintain profitable businesses.

You will be aware that whenever you open your wallet, by passing your money to someone else, you take substantial risks. Having your own assets will have taught you the skill of assessing the odds of success of each financial transaction.

This alone will prevent you from gambling and taking stupid bets in financial markets. You will most likely end up keeping your wallet zipped most of the time.

#4 Compare possible returns in the securities markets with your personal cost of capital

If you established your own cash engine first, and you have your own income-producing assets, you would soon realize that it would be foolish to put the money into the stock markets or any type of mutual fund all the time.

The reason is you usually get much higher and better returns from the assets you control. Always compare potential returns with the returns you can achieve yourself — at much less risk.

Buying index funds, that might make you 5%, but could cost you 50%, will be far less attractive a prospect than investing in your own business where you could make double-digit returns.

Ever wondered why top traders and investment managers are so eager to share their tips through expensive research and educational courses (present company included) or why they are so eager to manage your money?

Well, they know that doing this is a very profitable business model in itself that can generate generous returns with less risk and more predictable cash flows.

#5 Avoid overpaying for other people’s assets

The biggest risk in investing in financial markets is not price volatility but overpayment risk.

Overpayment risk is simply to pay too much for the value you receive in return, i.e. you get much less than previously anticipated. It’s common sense to ask for at least equal value for the price you paid.

Having your own income-generating asset would train you for this. Overpaying happens in public markets day in and day out. You always pay the price for popularity, and the result is mediocre returns or losses.

#6 Let diversification come naturally

Risk management involves assessing the odds of success with each financial transaction. Today, there is an overemphasis on diversification: people arguing the need to hold 500 stocks, or thousands of stocks, with hundreds of bonds and several funds spread over several asset classes at all times.

This is what I like to call “dumb diversification,” and it has its limitations. What you end up with is excessive diversification and meager returns at high fees. Any form of risk management costs money, even if you use cheap index funds.

Investing by definition means taking chances on the future. We cannot completely eliminate this through diversification. If you are worried about portfolio volatility, you shouldn’t invest in financial market instruments, but put your money in high quality fixed income securities.

Alternatively, with establishing your primary cash engine comes the understanding of natural diversification. All future cash flows must come from your primary income stream. Hence, efficient diversification means building several income streams over time that will allow you to withstand any financial shock.

You will never be forced to sell any of your assets at subpar prices. Keeping liquid assets, such as cash and gold, is your default diversification plan.

#7 Follow the 80/20 way to investing

Financial success relies on only a few decisions. We are our best cash generators. So, we should take care of ourselves first and our own business endeavors. Aim to simplify and streamline your investment strategy and portfolios.

By focusing only on the tasks and decisions that count in your life, you would naturally become more selective with your investments and how you spend time on them.

A consequence of this attitude would be only to occasionally invest in financial markets; in other words, when you are getting offered unbelievable odds of winning and true value that make all your efforts worthwhile.

Ask yourself if you want to spend countless hours sitting in front of the screen and listening to the BS of so-called experts when you could be investing in your own business platform or simply leading a more balanced life.

# 8 Never forget Rule #1

All the rules mentioned lead back to the mother of all investment rules: Never lose money. By establishing your own income producing assets first, you will inherently appreciate this rule right from the start, instead of betting on price differentials and rising markets.

With creating your own assets comes education and awareness. It would teach you how to take calculated risks while demanding appropriate compensation. You will instantly understand that the prerequisite for financial success is having high standards while creating value for yourself.

For those already in business, and with plenty of cash, I would like to remind you how and why you got into the comfortable position you’re now in.

It was certainly not through speculating wildly in stock markets and other esoteric financial products or hoping that index fund portfolios grow at 7% perpetually into the future. I would like to refer you to Benjamin Graham’s observation:

“Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings.”

***

There you have it. 80/20 investing is all about improving the odds of your investment success by bundling your strength and resources. Ultimately, this will help you develop a strong mindset that will give you a psychological edge when financial markets go haywire.

80/20 investing is intelligent investing and 80/20 Investors are Superinvestors, because they strive for high returns by following just a few rules and avoiding mass deception and exuberance.

80/20 investing is ideal for individual investors with an enterprising mindset because they can do what’s right in investing without following institutional imperatives or conventional thinking.

Originally published at 8020investors.com

In the competitive world of retail and institutional money management, no other company has made a bigger impact than Vanguard. It’s one the of the largest asset managers in the world, it has the largest fund in the world as measured by assets under management (AuM), and it is the lowest cost provider of them all — all thanks to the revolution of index investing, (‘passive’ money management), and the visionary leadership of its now retired founder, John Bogle.

That Vanguard dominates money management in, and for, developed countries is widely known. With their wide range of index funds and ETFs, they long ago won the intellectual battle of passive vs. active money management. The result has been constant growth in assets under management, a wider range of product offerings, and a continuous increase of new clients worldwide.

But it doesn’t stop here. Vanguard is also making strong efforts to spread their influence beyond plain vanilla product offerings (such as S&P 500 index funds) into the broad field of frontier and emerging markets investing. Here, the battle of passive vs active fund management still rages, and Vanguard is on a quest to win the whole thing for itself.

In this installment of our emerging markets investing series, we look at Vanguard’s efforts to dominate emerging markets investing, and how investors could make use of their product line while profiting from all the advantages emerging markets offer to enterprising investors.

Passive vs. Active Emerging Markets Investment Management

In a recent interview with Bloomberg, fund manager Robert Marshall Lee, of top-performing Newton Global Emerging Fund, commented on the passive vs active management debate:

“Competition from exchange-traded funds doesn’t even feature for me, I am very unconcerned…If you track the index you end up holding a lot of undesirable companies.”

The 22-year investment veteran based out of London has good reasons to be cocky. He had a good year in 2017, comfortably beating his emerging markets benchmarks by several percentage points.

And he is not alone. Within emerging markets investing, that statistics indicate how for the last 5 years, stock pickers have beat passive emerging markets funds 60% of the time. The question is — for how long will this continue and how long does Mr. Marshall-Lee stay with his firm, where the average holding period of a senior fund manager in the City is three to four years or less?

Emerging Markets Fund Management

Not to take anything away from Mr. Marshall-Lee, but there are good reasons to doubt his success going forward.

For one, emerging markets have become themselves more mainstream, and hence more efficient in processing investments and managing capital markets. This makes conventional stock picking more and more challenging.

On the other hand, the growing depth of low-cost passive managed index funds and ETFs from providers such as Vanguard will make life more difficult for traditional managers in emerging markets funds.

As index funds overran traditional money managers in developed countries, so will they overrun actively managed funds for emerging markets, as their sphere of influence increases and with that their entire range of operational advantages.

Star Fund Managers Come and Go

Someone who is certain of this is John Bogle, former head of Vanguard, and now celebrated guru of index fund investing. According to him, “It’s mathematically impossible to beat ETFs”. For him, it is only a matter of time before index funds and ETFs dominate emerging markets as well.

Besides, as with any institutionalized operation, emerging markets fund providers suffer from the same institutional imperatives as anyone else in the money management industry. The emerging markets investment industry is infamous for its very high management fees and the occasional blackouts by their star fund managers.

Whether Mark Mobius at Templeton or hybrid fund managers such as Anthony Bolton at Fidelity, the history of star fund managers for emerging markets is littered with dead bodies and broken dreams of former fund management celebrities.

Mr. Marshall-Lee has had a good run, but so did all the stars before him. The question is whether he will be able to avoid this one year that may ruin his stellar track records and ultimately his client’s confidence forever. The odds are strongly against him.

For now Vanguard and co. might be underperforming fast moving stock pickers from active fund management firms. But you can be sure that — Vanguard won’t be worried about any of this.

Vanguard Emerging Markets Funds

Besides offering the leading index funds for the most important benchmark indices of the world, Vanguard early on adopted emerging market indices, such as the MSCI and FTSE index funds for emerging markets. They were conveniently grouped as the Vanguard Emerging Markets Index group of products.

With some delay over its competitors such as BlackRock or StateStreet, Vanguard added a whole line of ETF products, including emerging markets ETFs. The blame for this delay lies with none other than John Bogle himself, an outspoken critic of ETFs.

He believes that ETFs induces unnecessary trading by both speculators and retail investors.Nevertheless, he wasn’t able to block the rising popularity of ETF trading. Vanguard’s new management saw no other choice but to jump on the speeding bandwagon of launching any conceivable ETF possible.

Here is an overview of Vanguard’s most popular equities emerging markets index funds and ETFs:

Vanguard Emerging Markets Stock Index Fund Investor Shares (VEIEX/VEMAX)

This is Vanguard’s flagship emerging markets index fund, which is also available as Admiral Shares, and ETF. In its prospectus you can find the fund’s investment objective:

“The Fund seeks to track the performance of a benchmark index that measures the investment return of stocks issued by companies located in emerging market countries.”

The fees are moderate at 0.32% (expense ratio), and the minimum investment for retail clients is only $3,000.

At the time of writing, its fund size was over $100 billion, and its three largest holding was:

• Tencent Holdings Ltd.
• Taiwan Semiconductor Manufacturing Co. Ltd.
• Naspers Ltd

Alas, looking at its performance over the last 10 years, you will find a rather bleak picture. It wasn’t able to beat its peers in the active money management community, nor was it able to match the S&P 500’s 9.5% (2.25%) annualized performance — not even close. In short, you would have been much better off just buying the Vanguard S&P 500 index fund.

Vanguard FTSE Emerging Markets (VWO)

This Vanguard emerging markets ETF tracks the FTSE Emerging Markets Index. It is most likely the cheapest ETF for emerging markets retail investors can buy. With an expense ratio of only 0.14% it charges less than half the fee for its flagship emerging markets index funds the VEIEX, but with a very similar diversification and composition.

It holds over 4700 stocks and its three largest positions are identical to VEIEX:

• Tencent Holdings Ltd.
• Taiwan Semiconductor Manufacturing Co. Ltd.
• Naspers Ltd.

In its investment prospectus it states for its investment objective:

“The Fund seeks to track the performance of a benchmark index that measures the investment return of stocks issued by companies located in emerging market countries.”

More specifically:

• Invests in stocks of companies located in emerging markets around the world, such as China, Brazil, Taiwan, and South Africa.
• Goal is to closely track the return of the FTSE Emerging Markets All Cap China A Inclusion Index.

Unfortunately, it comes with an even more appalling performance track record than its close cousin the VEIEX. Over the last 10 years, it has achieved only 1.3% annualized returns.

Never Missing a Good Business Opportunity

Interestingly, Vanguard offers actively managed emerging funds as well. To hell with the whole childish debate over active vs. passive money management and futile ideologies when it comes to making a few more bucks.

Naturally, Vanguard’s actively managed funds come at a much higher management fee. For example, where their flagship emerging markets index funds charge 30 basis points, their actively managed equities funds for emerging markets charges 90 basis points.

For completion, we have added Vanguards flagship mutual fund for emerging markets actively managed by real professionals and stock pickers.

Vanguard Emerging Markets Select Stock Fund (VMMSX)

Asset class: International/Global Stock

Fund category: Diversified Emerging Markets

Management type: Active (Advised by Wellington Management LLP and other emerging markets specialists).

Minimum investment: $3,000

Expense Ratio: 0.90%

Fund total net assets: $819.5 million

Number of stocks: 314

Funds’ three largest holdings:

1 Taiwan Semiconductor Manufacturing Co. Ltd.

2 Tencent Holdings Ltd.

3 China Construction Bank Corp.

10 year annualized performance: 1.82%

Whether you choose a more traditional index fund or an ETF from the growing range of investment products that Vanguard offers depends on your own investment strategy, risk profile and how much involved you would like to get. Both options have specific benefits that can be incorporated into your personal asset allocation and long-term investment strategy.*

*Please consult with Vanguard or your private banker directly — without paying a high consultation fee.

Vanguard Competitive Advantage

For now, Vanguard Emerging Markets Funds may be underperforming its competition from the active management realm. But keep in mind — past performance is no indicator of future performance. Maybe Vanguard’s range of index funds and ETFs for emerging markets will see a roaring performance over the next 10 years, not only beating the S&P 500 but also its peers in the active money management community. It holds some aces up its sleeves and here is why:

A Firm without Stars

In a recent interview with Bloomberg News, Gerry O’Reilly gave a brief description and tour of Vanguard’s operations. O’Reilly is the senior portfolio manager at Vanguard, who oversees more than $800 billion in assets.

His main job is to make sure that Vanguard’s flagship fund, the Vanguard Total Stock Market Index Fund, matches the performance of its benchmark. What stands out is the efficiency of the 18 traders responsible for Vanguard’s entire U.S. portfolio — and their senior manager most clients have never even heard of.

This gives Vanguard an enormous competitive advantage over its peers in the active money management world. Everyone is replaceable without so much as a hiccup to Vanguard’s operations. Imagine Bridgewater Associates without Ray Dalio or Soros Funds without Soros. Expensive Star fund managers have no room in index fund operations.

In addition to not having to pay for armies of expensive star fund managers or research analysts, it has always had much lower marketing and advertising expenditures. It basically operates on a continuous word of mouth campaign which has seen an increased momentum over the last three years throughout the world.

Big is Beautiful & Profitable

Today, Vanguard employs 15,000 people in 16 locations worldwide, managing about $5 trillion in assets. Cash is flooding into a growing range of index funds and ETFs that track indexes of every conceivable investment segment — including Vanguard’s own line of emerging markets products.

All this money helps keep operational costs low, and these savings are then passed on to clients in form of reduced fees — the so-called ‘expense ratio’. With its growing asset size, Vanguard profited from economies of scale effect, which among others allowed it to negotiate fees paid to external third parties, such as brokers and banks.

Vanguard’s history of cost-cutting and reducing fees is impressive, and buying shares of Vanguard’s line of index funds is very affordable. In 2000, Vanguard was by far the lowest-cost provider, having slashed its expense ratio to 0.27 percent for its flagship funds, while the average fund charged 1.21 percent.

Through continuous investments in IT infrastructure and sophisticated software, Vanguard today is capable of charging only 3 to 4 basis points for some of its flagship funds to institutional clients and still operate very profitably. For retail clients, Vanguard charges $50 for a single share for its Vanguard Total Stock Market fund, with an initial minimum investment of $10,000.

Vanguard Emerging Markets — Destined for Success

It’s only a matter of time until index fund providers dominate emerging markets’ institutional money management as well. The days of traditional stock pickers at active fund management firms such as Robert Marshall-Lee or Mark Mobius (now retired) are counted.

The more emerging markets develop and grow, and the more emerging markets as an asset class is recognized in general, the more the advantage of passive money management will outshine those of active money management.

The fee differences today between passively managed and actively managed funds are so high (0.14 vs 2.50 to 3.00%), that it is only a matter of time until the majority of investors interested in emerging markets investing will catch on.

Vanguard on a Mission

In Boston and New York, the large majority of professional money managers did not recognize the disruptive potential that the concept of index and ETF investing contained. It seems they do the same mistake for emerging markets investing.

In 2018, more and more traditional fund managers in the active only camp lose assets at an accelerating momentum. This includes firms such as Franklin Templeton or Fidelity while the leading providers of passive management absorb those assets their competitors are losing.

In this race for passive management dominance, Vanguard will play a very special role. It’s cost competitiveness, its growing brand awareness among institutional and retail investors, and its excellent global infrastructure are all excellent arguments in Vanguard’s favor.

Vanguard is, and remains, “the Walmart of money management,” In the mid to long-term, Vanguards structural and operating competitive advantages will break through in emerging markets investing as well.

A Few Questions Remain

Some questions remain in our series of investing in emerging markets. For example, how to allocate to emerging markets, and how the 80/20 Investor sees the performance potential of emerging markets going forward. All these questions and more will be answered in our monthly premium newsletter: The Monthly Truffle.

On our blog will continue reporting on the development of specific emerging market countries and companies that offer great investment opportunities. Also, stay tuned when we have a closer look at Vanguard’s fiercest competitor: BlackRock.

Subscribe to our regular email updates and get your FREE membership to get access to all our FREE resources for 80/20 Investors.

If you are interested in our Premium Newsletter — The Monthly Truffle — continue reading here.

*****

APPENDIX: Vanguard — A Brief History

Vanguard originated out of a corporate power struggle at the top of Wellington Management, one of the oldest mutual fund companies in the USA, that took place between 1973 and 1975.

This power struggle, caused and lost by John Bogle, left this young and uprising star manager with only two options: Either leave Wellington or be demoted to take over the administrative functions, of Wellington Funds far away from the centers of power. Surprisingly, Bogle opted for the latter, but with some aces up his sleeve.

Wellington’s remaining board of directors didn’t think much of Bogle’s choice. In their eyes, he was out of the game and without any real power such as raising funds or managing money. However, they underestimated Bogle’s resolve and resourcefulness.

In May 1975, a new administrative entity was launched called Vanguard Group (The Vanguard Group of Investment Companies). It soon became apparent, that Bogle had much more in mind for this newly established entity than just doing mundane paperwork for his adversaries at Wellington.

Strangely enough, the Vanguards’ board, which was distinctly different from the board of the investment advisor Wellington, had more power to influence the day-to-day operations than anyone had anticipated. This new found power left Bogle with plenty of room to make life at Wellington more than complicated.

However, one problem remained for Bogle. Under contractual obligation, Bogle wasn’t allowed to actively raise money through classic sales distribution channels or manage money.

So, how could he overtake vital management functions, while slowly detaching himself from Wellington? It dawned on him that the idea of creating the first index fund was the perfect solution to circumventing his agreements and a way out of his deadlock.

With passively managed index funds, he neither used an expensive sales and distribution network which was the traditional way of placing funds with clients. Nor would he actively manage any money — as technically no active advisory mandate was necessary for creating an index fund. After all, all he had to do was to copy a basket of stocks that represented an index such as the S&P 500.

The First Retail Index Fund

The plans took shape all through 1975 and finally, in August 1976 the Vanguard Group would launch the first publicly available index fund. The revolution was born and they would make their mark on money management history.

But initially, Bogle’s index fund met strong resistance from within and outside the money management community. Too strong were old believes and too hardened were the power ties of and an old-boys network that controlled institutional money management.

Including Wellington directors, many professionals ridiculed Bogle’s foray into passive investing, calling it “unpatriotic,” “Bogle’s Folly” or accusing the rationale behind passive management of aiming to be “average” — a very un-American ideology, indeed. By the end of 1976, the Vanguard fund had grown to only $14 million.

But entering the roaring 80s, Vanguard would collect more and more assets through more and more fund launches. Partially due to a recovering economy; partially because more and more investors understood the rationale behind passive management and its advantages over old-fashioned and expensive money management operations.

By the beginning of the 1980s, Vanguard had collected $2.4 billion. By 1999, the year Bogle left as Chairman of Vanguard, the figure would swell to $540 billion. At the beginning of 2017, that number was about $4 trillion with new estimates of $5 trillion by the beginning of 2018.

Originally published at 8020investors.com

In this article we will discuss the question of what is the best emerging markets investment strategy. We will be looking at the approach some very successful value investors have applied to investing in high growth economies. For contrast, we’ll describe the conventional approach to emerging market investing still favored by the majority of asset managers. We will look at what the perfect investment vehicle would be for executing the best possible investment strategy for emerging markets.

Don’t Go for the Conventional Advice

In late 1986, an unknown family office called Sovereign, with roots in New Zealand, and $10 million under management, made its debut investment. Only a few months prior, the family had sold its retail business in New Zealand. Now they were eager to deploy their assets in global capital markets.

Surprisingly, their first investments wasn’t a managed fund by a leading broker or private bank from Switzerland. They weren’t interested in the standard sales talk of asset allocation strategies and portfolio theory, that would spread their money in hundreds of companies and bonds in the US and Europe. Instead, they would buy one piece of real estate in Hong Kong putting their entire $10 million on the line.

Lead by the two sons, Richard and Christopher Chandler, the family office bought a 22-story building in heart of Hong Kong for $27.6 million in February 1987. Only 4 years later they would sell the building for more than $110 million, boosting their wealth from $10 million to over $40 million in the process.

In an interview the brothers would explain their rationale: Real estate prices in Hong Kong were depressed trading for 70 percent lower than their peak prices in 1981. Investors were spooked by the ongoing negotiations of Hong Kong rejoining China to be finalized in 1987. The two brothers noticed the opportunity, read the new treaty with China, and decided that the general fear of uncertainty was overblown. The rest is history.

Searching for Opportunity — The Sovereign Approach

The Chandlers would use this experience as a blueprint of a very profitable investment strategy that generated an investment track record any conventional asset manager can only (wet) dream about. In the years that followed they would refine their investment approach by replicating the same type of investment over and over again — often in emerging market economies.

For example, in the early 90s, they would buy Brazilian Telecom stocks and Venezuelan Power bonds at bargain base prices and made a killing. They also bought a whole range of Brady Bonds when the investing public was just beginning to catch on.

After that they bought Russian assets in oil and gas, only to sell most of it at the height of the Russian stock market boom in 1997. Knowing Russian capital markets, they repeated the same spiel 10 years later. This time they would buy Russian banks at the height of the subprime crisis, which suffered like any financial institution from the general fear of a global financial meltdown. They doubled their money within a year when market conditions returned to normal in 2009.

In between their Russian investments they would buy Japanese banks when there was total financial meltdown between 2002 and 2003. After that, they bought Chinese assets when the BRIC acronym was just starting to make rounds in the boardrooms of large asset managers.

Favorable Valuations and Focus Portfolio Management

On the surface, the Chandlers followed a very simple value investing strategy with a focus portfolio investment approach. They searched for mispriced assets all over the world, did their research, and made concentrated commitments when they understood the risks involved.

Their investments would usually end when the general investment public got interested in mispriced assets. The lapse could last a few years or just a couple of months depending on capital flows and global investment trends.

In many cases, they would sell too early or not capturing the entire boom phase. They weren’t bothered with this, as their average annualized returns were far superior to any conventional asset allocation strategy. It wasn’t their primary goal to have a perfect timing or to beat benchmarks. It was to simply make a killing.

Sometimes they kept on holding a few strategic long-term investments through the boom and bust phases, adding to them during stronger corrections. China is a good example — they still hold investments they made in the mid-2000s, with some fantastic capital gains accumulated over the years.

For the investments they kept for many years, they actively worked to enhance value. In case of real estate, hey would make improvements such as renovations or upgrades. In case of equity investments, they would call for corporate governance improvements that resembled the work of professional activist investors.

This small family office that started out with $10 million would become titans of international value investing. At the height of their success as a single family office, they would amass a fortune of more than $5 billion — all this with a simple strategy of understanding value and the nature of capital markets.

The Traditional Asset Allocation Strategy

Since the beginning of investing in high growth economies, institutional investors and individuals have been discussing what the best emerging markets investment strategy could be. How the majority approached this question could be seen from the history of emerging markets investing and as we know it wasn’t always pretty.

Sovereigns’ approach provides a fresh perspective and a valid alternative to how we as individuals should be investing in emerging markets. Their opportunistic investment approach stands in stark contrast to the conventional approach still favored by institutional and retail investors alike.

When Sovereign bought, most money managers would sell, and when Sovereign sold or reduced their positions, they would be buying. Let’s have a look at traditional money management and their approach to emerging markets investing.

What happens with your money? From advisor to emerging markets fund

When you enter a local bank branch, a friendly banker will discreetly analyze your current financial situation, income, age, and financial goals. Based on your answers, they will assess and set financial targets, such as your return goals, investment horizon, and risk profile (whether you are a high risk, medium risk, or low-risk taker). Then, they will devise an investment matrix to offer you the appropriate financial products.

The most important step in the whole procedure is the asset allocation decision, which is based on your answers to the questionnaire. This process divides your investment into asset classes that are considered appropriate for your risk profile. The most common assets classes are stocks, bonds and real estate.

Often, you will be presented with a pie chart slide depicting how much you should be allocating to each asset class, starting with default asset allocation models (where you put the majority in bonds, followed by stocks, or real estate).

Within each asset class, they will then recommend several investment funds, from either in-house offerings or third party providers, to fill up your personalized allocation model. Many times they will advise you to buy several funds at the same time for each asset class in question. Extra diversification not only within funds but also across fund providers couldn’t hurt — right?

Emerging Market Funds in Asset Allocation Management

Here is where today’s modern emerging market funds enter. Depending on how popular emerging markets investing is in the financial press, advisers will recommend adding a few emerging market funds to your mix of bonds and equity funds.

Their arguments will be based on past track records, the enormous growth forecasts by their expert research teams and the general sexiness of investing in exotic countries. It is also based on how top management at banks and private banks are pushing these high margin products on their army of financial advisors to promote to their clients.

From there, this portion of the money will flow to one of the many emerging market fund providers, where a team of MBA-educated professionals will strictly follow their orders as described in the shiny investment pamphlets you most likely held in your hands at your advisory’s office.

Here is a perfect example of such orders, taken from Templeton’s website on of the leading providers of emerging market funds:

Templeton Emerging Markets Fund: Investment Objective and Strategy

The fund seeks long-term capital appreciation by investing primarily in equities of companies in emerging markets. The fund may also invest in companies that trade in emerging markets, or that trade elsewhere in the world and earn at least 50% of their revenue from production or sales in emerging markets.

It’s only common sense that a financial advisor who needs to earn a living won’t sell you anything that would send you sprinting out of their office like you’d been bitten by a tarantula. They offer products that are hip, widely spoken of, and that can earn them a decent commission.

On the other hand, it’s only natural that professional portfolio managers only do what they are supposed to be doing with the money entrusted by their clients. Besides they want to hold on to it as long as possible so that they can earn a management fee.

But this is where the chain of unfortunate investment decisions starts that can be particularly fatal when it comes to investing in emerging markets. Remember — popularity investing has never been a guarantor of investment performance especially for emerging markets.

The Institutional Imperative

Traditional money management has always been dominated by large investment pools, controlled and managed by giant investment firms or financial institutions. In the past, it was institutions like Bank of America or Citigroup that lead the way in promoting and investing in emerging markets. Today, BlackRock, Vanguard or active managers such as Templeton or Fidelity dominate the market for high growth economy investing.

As gatekeepers to international stock markets, they control the investment process and flow of capital around the world. But having a dual objective of delivering high performance to their investing clients while also satisfying their own shareholders is usually riddled with conflict of interests. The competitive forces of free market economies dictate the mission of being profitable, which in turn determines their investment approach. And their business mission is clear: Amass Money!

This, however, often leads to what Buffett calls the “institutional imperative” among money manager — a herd mentality that results in behavior contrary to what common sense would dictate. As a fellow value investor would sum it up nicely.

It’s the tendency for organizations to:

- resist changes in direction;

- make less than optimal use of corporate funds;

- support even very foolish initiatives;

- imitate, at times rather unwisely, the actions of peer companies

The impact on institutional money management is that their investment process is driven by maintaining markets share, and, ultimately, the objective to maximize assets under management over their peers. This often leads to business and investment decisions that are more dictated by making their own shareholders happy, which in turn guarantees jobs and fat bonuses.

In short, the financial incentives at the top of money management are perfectly aligned with the safety of the herd, and what’s going on at their corporate boards. When it all goes well it’s the genius of the management team. When it goes bad it’s the fault of the markets or the FED or something else.

The Usual Outcome of Conventional Investing Methods

This behavior can be fatal and involves relearning a lesson over and over again: Real economic growth rates and growth forecasts don’t translate into 1:1 investment performance. This old mechanism, mixed with the usual psychological flaws of large groups of less sophisticated investors, guarantees a place on the losing side.

The hype around BRICs related emerging markets funds that peaked in 2011 is a perfect case in point. Even though the BRIC economies would deliver high GDP growth beyond 2011, investors suffered underperformance or even losses. Capital markets quickly priced in growth rates far into the future at a mind-boggling speed. Only early adopters and pioneer investors would reap outsize profits. Latecomers would foot the bill.

But what made it worse were the exorbitant fees money management firms would charge for the privilege to invest in exotic growth markets. Sometimes clients would have to fork over three to four times as much as standard mutual fund would charge for plain US stock funds. Good times for traditional asset managers reaping high profits, while investors lost money would soon be over.

Buy and Hold with Index Funds & ETFs

Rather than making adjustments to a flawed approach of popularity investing, the money management community’s attention moved from the investment process to the investment products themselves. In their eyes, the real issue with losses and sub-par performance was quickly identified — horrendous fees charged by active managers.

In order to counteract their clients’ moronic behavior of buying late and selling late, and paying high fees in the process, a special camp of the investment management industry had been working on a technological revolution since the late 1970s. It would take care of the high fees issue, and incentivize customers to stay invested at all times — Index funds and ETF investing — so-called ‘passive’ investment vehicles.

The theory behind it is that in a new age of algorithmic, computerized trading, index funds and ETFs will give you maximum diversification at low cost while reaping market performance as measured by a chosen benchmark index. Being invested at all times and adding to them on a monthly basis discourage you from buying late and selling even later while participating in whatever is hot among investors.

Emerging Markets Index Funds and ETF investing

This revolutionary doctrine would be applied to emerging markets investing in earnest from 2010, and with great success. Money managers would either allocate a portion to emerging markets through index funds and ETFs to their own fund compositions, or they would give clients the opportunity to decide for themselves through a whole new range of individual emerging market index funds and ETFs.

ETF products like the BlackRock iShares Core MSCI Emerging Markets ETF (IEMG), continue to see astounding growth in assets. According to MarketWatch.com “Year-to-date, investors have added nearly $3 billion in new assets to IEMG alone, a tally exceeded by just two other ETFs “IEMG added $16.57 billion in new capital last year, making it 2017’s fourth-best ETF in asset-gathering proficiency.”

Unexpected Side-Effect with Similar Outcomes

The result is that anyone believing the new doctrine joins the herd, with all its consequences and side effects. And contrary to all the risk diversification mantra, only three institutions combine more than $16 trillion assets under management of a global $40 trillion pie. Frighteningly, this concentration seems to be accelerating. How is this for efficient risk diversification?

Let’s be honest: What is proclaimed as being passive isn’t passive at all. Decisions of whether to overweight and underweight, regional allocations etc and which service provider to choose from still have to be made with passively managed products.

An individual investor still has to pick their private banker and an investment advisor still has to decide which ETF or index fund to offer their clients, and that isn’t as easy as it used to be. According to industry experts, there are now more ETFs and index funds than the individual securities they pool together.

So there’s plenty of room to mess up the selection of the right advisor, the right provider and the right index funds and ETFs that could ruin your overall benchmark performance. Here is where the real risks for individual investors lurk. As the last financial crisis in 2007 proved, investors would panic and will do so in the future, with or without index funds and ETFs.

The Best Emerging Markets Investment Strategy

It’s clear that a simple buy and hold, or overweight and underweight, allocation strategy doesn’t work for the individual investor when it counts, regardless of the size of fees being charged. It still exposes them to extreme psychological reactions that come with auction-led market pricing, where greed and fear take their toll.

Instead of following the conventional approach to emerging markets investing, the best approach is a similar strategy to what the Chandler Brothers at Sovereign Global and other value investors such as John Templeton or Seth Klarman have done before:

‘Opportunistic Value Investing Approach’, with the help of ETFs and Index funds.

80/20 Investing for Emerging Markets

Pareto’s Principle, also known as the 80/20 principle, demonstrates that only a minority of causes lead to the majority of results. Studying the lives of very successful entrepreneurs and investors, only 20% or less of them generated more than 80% of contemporary investment performance. Only a few factors contribute to extraordinary investment success.

Studying these factors and focusing on these will greatly reduce your workload in the investing process, and at the same time increase your potential performance and chances for success. This is in stark contrast to the conventional approach to asset allocation.

Let’s have a closer look at these possible factors that could lead to investing success. The strategy we favor to investing in emerging markets is on an investing classic “Rich Man, Poor Man,” by Richard Russell. In it he describes it as thus:

…When bonds are cheap and bond yields are irresistibly high, he buys bonds. When stocks are on the bargain table and stock yields are attractive, he buys stocks. When real estate is a great value, he buys real estate. When great art or fine jewelry or gold is on the “give away” table, he buys art or diamonds or gold. In other words, the wealthy investor puts his money where the great values are.

We would add, when specific emerging market economies or entire regions are cheap, and investors flee in droves, you start investing. You sell when easy money and heightened interest induce the majority of investors to buy. In this approach, you simply make use of opportunities that financial markets offer you.

This way, you achieve outperformance as early investors and avoid taking part in horrendous losses when entire markets collapse. This approach is surprisingly simple. It requires some understanding of valuation models, appreciation of cash as a default asset and some simple market insights that can be easily attained by visiting the countries and companies in question. In short — it’s not rocket science.

The perfect investment vehicles for Emerging Markets Investing

It may be a surprise — but the perfect investment vehicles to execute such a strategy are in fact index funds and ETFs. This might sound contradictory, but the main purpose is not to trade in and out on a daily basis, or hold them forever through thick and thin, but to capture value at low cost and at your convenience.

Let me elaborate: The opportunistic value investing approach invests in emerging markets whenever they offer outstanding value at manageable risk. Certainly, you can’t be an expert in all of these asset classes, industry sub-sections, or individual securities. The solution is to buy low-cost index funds or ETFs that mirror the emerging market economy, or even specific industries in question.

Here, all the core advantages of passively managed products will come to fruition. Instead of being charged 2% or more for a hot investment fund managed by a star manager, you are being charged about 30 basis points for a standard emerging market index fund and a bit more for specialized industry or theme index funds.

You get maximum diversification at the lowest fees possible with maximum transparency managed by an institution that is, most likely, too big to fail.

*****

Certainly, there is room for discussion of what is, in fact, the best emerging markets investment strategy, but the success of previous Superinvestors speaks for itself. Contrast these with those who were constantly on the losing side of investing in emerging markets and you get a much better picture of what strategy and approach you should be following.

In the following articles on investing in emerging markets, we will cover our personal outlook for 2018 and we will have a closer look at specific index fund providers that offer emerging market funds.

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