Author: Leela Vosko, Director of Marketing
The aftermath of the 2008 financial crisis left few portfolios unscathed. While global investors stressed over the volatility of traditional asset classes, an entire asset class of Microfinance and SME Finance assets in emerging markets proved remarkably stable, leaving many to wonder, whether a performance like this could repeat itself when the next crisis in global financial markets inevitably happens.
COVID-19 proved to be that test. While both developed and emerging market equities declined sharply before fiscal and monetary policy came to the rescue and enabled some major indices to reach all-time highs, the Symbiotics Microfinance Index (SMX-MIV), which tracks the monthly performance of Microfinance Investment Vehicles (MIVs) whose assets are invested in fixed-income instruments, continued generating steady monthly returns and exhibiting low to negative correlation with broader indices. (Exhibit1)
The two principal drivers behind the low correlation are 1) Diversification across geography & sector and 2) Focusing on the under-served is its own form of diversification.
Diversification across geography & sector
Though the Microfinance and SME finance asset class has historically been deployed only in emerging countries, this asset class’ correlation with publicly-traded emerging markets has been low to negative. As Exhibit 1 shows, emerging market stocks have tended to track the drawdowns of major indices. This is partly because the same investors who buy developed market stocks are also allocating to emerging market equities.
The universe of developed market stocks is much larger than the set-in emerging market countries that the average investor is used to encountering. Emerging Markets investing has historically been dominated by the large economies of Brazil, Russia, India, and China (BRICs), and there are a selected number of additional large countries with populations of over 100 million that can also be attractive to investors because of their demographics and growth rates. In some cases, index providers classify as “Emerging Markets” countries that many believe have graduated from this designation (i.e., South Korea). As a result, the universe of publicly-traded stocks is still concentrated on the BRICS and even those names may not be representative of the country’s economy as a whole. Industries with public companies in emerging markets often include financial services, energy and telecoms, though we are gradually seeing more technology companies going public.
However, looking under the hood of a typical emerging markets ETF or index fund reveals that a small number of stocks may disproportionately drive performance of the entire fund even if it is advertised as offering broad emerging markets exposure. For example, in the case of the Vanguard FTSE Emerging Markets ETF, which is among the largest emerging-market ETFs by assets, the top 10 holdings accounted for 24.7% of net assets as of April 30, 2021 with 40.7% of assets invested in China-based companies.1 With large-cap companies in several major countries dominating a typical emerging markets index, there is greater chance that overall performance may be linked to global sentiment on particular industries, economic outlook or geopolitics, all of which tends to increase correlation with mainstream equity and bond market performance.
In contrast, an average portfolio of Microfinance and SME Finance Institutions often has investments in more than 25 countries that range significantly from BRIC members to frontier markets, often much smaller as measured by GDP and sometimes by population. These would likely go uncaptured by a major index or receive only a very small weight. Even within a particular country, the Microfinance and SME Finance Institutions and their end borrowers are often located across small cities or in rural areas, because that is where unmet demand from micro-entrepreneurs and small businesses prove greatest. This further insulates a portfolio of microfinance investments from the fluctuations of the stock market.
Focusing on the under-served is its own form of diversification
MicroVest’s thesis, and that of the overall microfinance sector, is that major financial institutions in developing countries, the very ones more likely to be listed on stock exchanges and incorporated into emerging market indices, fail to include the underserved Microfinance and SME sector, because they were never designed to include them in the first place. By providing loans to responsible Microfinance and SME finance Institutions who do focus on these customers, MicroVest’s investors are ultimately investing in businesses that are interwoven into the fabric of their local economies but have historically been unable to access credit from the formal financial sector.
Due to their roles in local communities, many businesses provide essential services that cause them to be shielded from market volatility. A brief review of these end borrowers across our portfolio reveals micro and small businesses in deep and diverse sectors like services (hairdressers, transport, repairs), light manufacturing (clothing, furniture, construction), distribution and commerce (shops and wholesale), SME businesses with local export supply chain linkages (manufacturer of crates for a local Coke bottler), and leasing. Many of these businesses are resilient to local economic conditions or play a vital role in local supply chains that keep communities functioning. These borrowers also exhibit low default rates,2 which drives steady returns across economic and market cycles. The default rate of the borrowers across MicroVest’s portfolio of Microfinance and SME Finance Institutions is 0.5% as of May 2021.3
How do Microfinance and SME Finance portfolios compare to other Private Emerging Market Strategies like PE/VC Funds?
Emerging markets private equity and venture capital offers investors higher potential returns relative to microfinance or private debt, but this comes with an elevated risk profile. The economics of a private equity or venture capital fund create the need to run a much more concentrated portfolio. Because investors are seeking large markets and need to consider how they will ultimately exit their investments through a trade sale or an IPO, many funds confine themselves to only a handful of large emerging markets where there is sufficient liquidity and high growth prospects. Depending on the balance between the supply of quality investment opportunities and the demand to deploy capital, this can leave many investors chasing the same handful of high-quality opportunities, which risks bidding up prices. Furthermore, because the timing of cashflows is hard to anticipate, it is impractical for these investors to directly hedge currency risk. All of this means that the best performing funds can create outstanding returns, but the dispersion across the asset class is very wide, making access and ability to select the best fund managers even more crucial relative to the job of a developed market capital allocator.
Through a portfolio of Microfinance and SME Finance Institutions, investors are still able to get access to private companies that they could not otherwise access on their own. Though lower yielding, private debt instruments are self-liquidating, and the ability to anticipate cashflows allows for hedging FX risk. Because the private debt investor already has a clear visibility into how the exit will happen, they can afford to invest in smaller countries, especially ones with relatively less mature financial systems, where private equity and venture capital investors would struggle to find investment opportunities. Since many of the communities that MicroVest serves often have significant unmet needs for capital, it is possible to deploy additional capital into various Microfinance and SME Finance Institutions provided the investment still fits within our portfolio risk parameters.
Even as global markets hit new highs, the SME finance gap in emerging markets will remain very large, which leaves no shortage of opportunity to deploy capital into best-in-class Microfinance and SME Finance Institutions. Furthermore, because end borrowers will continue to play foundational roles in the economies of their communities and remain very good credit risks regardless of global macroeconomic forces, we expect microfinance to continue to show low to negative correlation with other asset classes.
*The SMX-MIV Debt Index tracks the monthly performance of microfinance investment vehicles (MIVs), most of whose assets are invested in fixed-income instruments. The SMX-MIV Index returns do not include fees or expenses. Past performance is not indicative of future returns. Investors’ performance will vary depending on individual dates of admission. There can be no assurance that the Funds’ investment objectives will be achieved or that its historical performance is indicative of the performance it will achieve in the future.
3 Based on self-reported data from MicroVest portfolio companies across all funds as of May 2021.
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