Small but mighty shorts fuel Fidelity Emerging Markets recovery

Small but mighty short positions have been a key tenet of the recovery in Fidelity Emerging Markets (FEML ), according to manager Chris Tennant. 

Fidelity’s Chris Tennant says the recent recovery of their investment trust has been helped by its ability to short emerging market stocks, a relatively unique feature of the strategy. 

Tennant, co-manager of the £500m trust said that shorting - which is a bet on a stock falling rather than rising - has been key to turning around performance over the past three years. 

Tennant and co-manager Nick Price endured a tough first year after taking the trust over in 2021, just after a peak in the trust’s shares and before the Russian exposure was written down to zero at the start of the war in Ukraine. 

During 2022, shareholders lost 25% versus the milder 9.6% fall for the MSCI Emerging Markets index, according to Morningstar data. 

However, performance has picked up since and on a three-year view, shareholder returns have been 33.9%, including dividends reinvested, versus 16.9% for the benchmark. 

Returns have been particularly good year-to-date, with the shares returning 11.4%, according to Deutsche Numis data.

Short strategy

FEML is unique among its peers for having an active short book, targeted at low quality businesses, including ‘companies that are conducting fraud or have too much debt on their balance sheets, [and] companies in structural decline’, said Tennant. 

The managers use the cash from its short successes to extend the long book, made up of quality equities largely within emerging markets. Long book exposure is typically around 130% of the trust’s total net asset value, while the short book sits around 30% - one offsetting the other. 

An example of a short from which FEML recently profited was Lojas Americanas, the e-commerce platform in Brazil.  

‘The company was losing a lot of share to Mercado Libre, Amazon and Shopee,’ said Tennant.

‘It ended up hiding a lot of debt off balance sheet and that eventually came to light when there was a management change. There were a lot of red flags around the accounting of that business, which is why we were short.’

In the trust’s latest annual report, two short positions were in the top 10 contributors to relative returns, with the managers calling this ‘a notable achievement’ given the size of individual short positions is limited to around 100 basis points. 

In Tennant’s view, the big returns from shorting have been partly ‘a function of high interest rates’. 

‘These businesses tend to have a lot of debt on their balance sheets. So, when rates are elevated like they have been in recent years, that makes it harder for them to pay their interest bills and roll their debt,’ he said.

‘That’s one of the reasons it’s been a pretty good period for the short.’

The trust’s strategy also includes a hedging mechanism, which provides a little income to the trust. 

‘We’ll sell calls against longs and puts against things that are short and that provides a consistent level of income for the trust. It doesn’t massively move the needle but adds about a half to one percent every year,’ Tennant explained.  

‘Stars align’

It is not just short positions that Tennant is confident about as he believes emerging markets are due for a turnaround. 

‘It seems like all the stars aligned’, he said. 

‘The starting point for valuations is extreme, particularly in Latin America, the dollar has started to weaken, and China is pursuing a more expansionary policy agenda. I think that’s a very favourable backdrop for emerging market equities.’ 

FEML has a bias towards small and mid-caps but is not exclusive to this area, with its two biggest holdings being Naspers and TSMC. 

The trust is overweight Latin America, viewing Brazil, and Mexico in particular, as a relative winner from US tariff policy and a future ‘source of nearshoring for the US’.

Regarding China, the managers take an ‘active’ approach. Tennant said the trust currently shies away from banks, property and the heavier industrial sectors – steel, cement, petrochemicals, for instance – on concerns of ‘oversupply.’

Instead, the majority of China holdings are in the domestic consumer space. 

More unusual for an emerging market trust, FEML is underweight India.

‘The markets have just done so well in recent years that valuations are a bit more challenging,’ said Tennant.

Other factors that set FEML apart from its peers include its capacity to invest outside of emerging markets into frontier regions, with holdings in Vietnam, as well as 12% of net asset value in copper and gold mining. 

As of the latest annual report, the trust had a 3.1% exposure to Mexican mining, transportation and infrastructure company Grupo Mexico.