Taiwan Semiconductor Manufacturing Company (TSMC) has rocketed higher in recent years to a point where it dominates emerging market and Asian indices. While passive funds have benefited, active funds risk being left behind.
At 15.6% of the MSCI Emerging Markets index and 15.4% of the MSCI Asia Pacific ex Japan benchmark, the stock is too large for UCITS-regulated active managers to even take a neutral weighting.
This is a problem for managers who like the stock, such as Chris Lo, head of research-enhanced strategies at Columbia Threadneedle, who manages the firm’s suite of equity exchange-traded funds (ETFs), separately managed accounts and index mutual funds.
For example, the firm launched CT QR Series Emerging Markets Equity Active UCITS ETF aiming to beat the benchmark with a 3-5% tracking error.
In the fund, he holds a 7% position in the stock. “We like TSMC,” he said, but UCITS rules dictate that actively managed funds cannot invest more than 10% of their portfolio in a single holding.
“When TSMC, let's say, is 14.5% and our max is 10%, we have an underweight at 4.5 [percentage points],” he said.
Yet the fund is up on the MSCI Emerging Markets index in its very brief period on the stock market, despite TSMC rising some 17% during this period.
The way Lo gets around the TSMC conundrum is to invest with sector- and country- neutral allocations. As a result, he has used the relative underweight to put money into the likes of Samsung Electronics and SK Hynix, two South Korean companies in the semiconductor space that have performed strongly in recent years.
“So even though we underweight TSMC, we're reallocating to names that are very highly correlated in performance. And semiconductors do tend to hover together,” he said.
Most of the underweight, however, has gone into MediaTek, which designs semiconductors for use in smartphones, televisions and other electrical equipment.
While only a 1.8% position in the MSCI Emerging Markets index, it is a 6.7% position in the ETF. This helps with the country allocation too, as the stock is listed in Taiwan.
“Because of the country weight awareness, we're not reallocating [solely] by overweighting Korea. We are still neutral to Korea and to Taiwan. We're actually allocating most of the underweight from TSMC to MediaTek. So still a Taiwanese semiconductor,” he said.
“This is why construction is important,” he said, adding that it is crucial investors choosing an active strategy ask how a fund reallocates its TSMC underweight.
“We found solutions. I'm not sure if other active managers have, you know, a way around the diversification,” he said, but noted that it is “very hard” to keep pace with the index.
While some may suggest using a different benchmark, he noted that the MSCI Emerging Markets index is the “gold standard” for the asset class, making it difficult for investors to turn away from.
The choice of index is therefore critical for an active ETF, as investors may not want returns measured against an alternative.
“So it's hard to say, okay, let's just choose a different one, because then that benchmark will underperform the one they're supposed to. It's a catch-22. You can switch it, and that benchmark can do better or do worse. But then that's not what investors ask for. So I think switching benchmark is likely not going to be a feasible solution for most active managers,” he said.
Lo's challenge in running money in emerging markets is a good example of the issue raised by Trustnet's conviction cap campaign, which has called on the FCA to review the UCITS rules that cap active funds at 10% in a single stock.
At present, active funds cannot have more than 10% in a single stock – a limit that rises to 20% for passive funds – and must not hold more than 40% in companies that are above a 5% weighting.
The 10% part of the rules has been the issue for Lo, but as yet the 5/40 element has not come into play, with the manager noting that this part of the rules is more generous than in the US, where there is a 5/25 rule.
This means managers cannot invest more than 25% of a portfolio in companies with a 5% or higher weighting, although there is no limit on single stock concentration.
He said: “As an active portfolio manager, the fewer constraints there are, the better it is for us. You know, we always like to have the optionality, if you will”.
“If we need to exceed the 10%, if we have the option to do it, great. I think the 40% should definitely still be there, because that is a concentration limit and a diversification requirement,” said Lo.
“The single name, I think, is a bit more restrictive. I like to have an optionality to say 'okay, I do like this name and the benchmark has this exposure'. I may not necessarily take up the entire exposure. Maybe if it's 15%, I might go up to 12%. But not having that optionality means I have to seek out alternative solutions.
“Right now we have one, but we may not have one someday. I don't know in five years from now if the selection universe allows me to do that. So the rule of thumb is the fewer constraints, the more optimal my portfolio would be in terms of risk-return profiles. So that would be my preference.”