As a region in transition, Asia rewards the investor with an open mind and access to a full set of tools. This is Part Three of a five-part special report on Investing in Asia.

Given what we now know about the potential risks and rewards offered to U.S. investors by the long-term march of the Asian consumer, which tools are best suited to the job at hand?

For clients less familiar with Asia – perhaps those transitioning from a limited diversification play to a more substantial stake in the region’s stock markets – is the sharp scalpel of an actively-managed specialist fund the obvious choice? Or will a more user-friendly index-tracking vehicle such as a broad-based ETF be more cost-effective? Are small funds better than larger; or country- and thematically-focused vehicles superior to regional ones? And does top-down trump bottom-up? All approaches are valid (and available), depending on pocket size and risk appetite.

Matthews Asia portfolio strategist David Dali has no reservations about financial advisors starting off their clients’ emerging Asia exposures via ETFs. “Advisors should tell their clients to look outside the U.S. for growth. Start simple with an ETF, then add via an actively-managed fund or two to gain exposure to mid-caps,” he suggests.

Passive vehicles have challenged the primacy of actively-managed funds over the past decade, accounting for close to half of equity assets under management in both the U.S. and Asia. Although performance data remain inconclusive, active managers argue that the rise of passive is more justified in developed markets, partly due to the impact of quantitative easing on U.S. and European asset prices. They also cite the specific challenges of investing in less-mature, less-familiar and more diverse regions.

“Start simple with an ETF, then add via an actively-managed fund or two to gain exposure to mid-caps.”
David Dali
Matthews Asia
In emerging Asia, large-cap stocks dominate indexes, meaning market cap-weighted ETFs typically invest in a small number of longer-established stocks in low-growth industries. This can make them more susceptible to cyclicality, and less exposed to mid-tier firms operating in higher-growth, consumer-facing sectors, which are more likely to be privately-owned, better managed and more sensitive to the needs of U.S. investors.

“Active management is outperforming in EM, compared with developed markets, largely because the former are in an early stage of development and typically tend to overshoot on both the upside and the downside,” says Aditya Kapoor, co-portfolio manager of the Ivy Investments Emerging Markets Equity Fund.

Peter Williamson, founder of Asia-focused boutique Lovina Capital, warns that the apparent vices of ETFs are also common to larger mutual funds, asserting that many are undifferentiated, containing a similar range of stocks to each other and passive vehicles. “Many investors would be better served simply owning an Asian ETF or individual stocks if they are not prepared to seek out specialist active Asian funds,” he says.

Specialists will also claim that managers of both large mutual funds and ETFs are less able to identify the most compelling Asian growth stories, as they lack the necessary resources or analytics to pick long-term winners. Emerging Asia’s consumer-led economies now provide a stable backdrop for investment in firms with a proven track record in cash-generative growth, says Edmund Harriss, investment director at Guinness Atkinson Asset Management, who runs a bottom-up fund that invests in dividend-paying stocks across Asia. “This fully-fledged consumer market is contributing to the investment universe of firms that can convert the overall macroeconomic story into cashflows,” he says.

“U.S.-China tensions are leading many allocators to be more thoughtful about their EM Asia versus China exposure. There are both strategic and tactical reasons for looking beyond China.”
Chris Dhanraj
But Ivy Investments’ Kapoor says a mix of top-down and bottom-up can suit a region in transition. “You have to take account of the potential impact of a[n Indian President Narendra] Modi, for example, to drive structural reforms in India, but this has to be balanced by the value of analysts who monitor earnings performance and develop investment themes,” he explains.

If the best active funds are the skillfully-wielded scalpel, carving out opportunity, perhaps the ETF is the torch, lighting the way to new territories. But ETFs can play a more nuanced role too, for example, offering exposure to China’s consumer, via small- and mid-cap-based instruments, as well as country-focused vehicles that can help to reflect the dispersal of supply chains and manufacturing hubs across Asia. According to Chris Dhanraj, head of investment strategy at iShares, investors are actively allocating to non-China EM Asia, citing strong inflows this year into the firm’s Philippines ETF.

“Investors who understand the China investment story are now looking at other countries too. U.S.-China tensions are leading many allocators to be more thoughtful about their EM Asia versus China exposure. There are both strategic and tactical reasons for looking beyond China,” he says.

Next: Asia’s Honor Roll offers Opportunity for Straight-A Local Investing