Dear Fellow Shareholders,

I am once again pleased to address you on behalf of the Seafarer Overseas Growth and Income Fund. This report addresses the first half of the Fund’s fiscal year (May 1 to October 31, 2013).

During the semi-annual period, the Fund’s Investor and Institutional shares gained 0.90% and 1.00%, respectively. The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, rose 1.42%. By way of broader comparison, the S&P 500 Index increased 11.14%.

The Fund’s two share classes began the fiscal year with net asset values of $11.91 per share. Near the end of June, each class paid a semi-annual distribution; $0.145 was paid to the Investor class, and $0.147 to the Institutional class. Those payments brought the cumulative distributions per share (as measured from the Fund’s inception¹) to $0.256 and $0.269, respectively. The Investor Class finished the semi-annual period with a value of $11.86 per share, while the Institutional Class finished with $11.87.

Time and Perspective

2013 has not been a particularly rewarding year for those investing in the emerging markets. Stocks in the developing world have been volatile, and when measured year-to-date, they have produced only modest gains. Emerging market bonds and currencies have fared worse. Economic performance and corporate profits have disappointed many investors, especially those that held outsized – if unrealistic – expectations for growth. The developing world has provided plenty of cause for frustration; yet the greatest source of dissatisfaction has been the implicit “opportunity cost” of sustaining an investment there. Equities in the developed markets have performed exceedingly well, led by the U.S. The foregone opportunity to invest in the U.S. has come at a high cost, especially when compensated by the anemic performance of the emerging markets.

Yet, as frustrating as this year has been, I do not think it matters much to the long-term investor with an objective perspective. I do not state this flippantly. I know that some investors cannot afford to wait for the ephemeral and eternally-rosy “long-term” to finally arrive. The global financial crisis of 2008 inflicted terrible damage on some investors’ portfolios, and their retirements loom. I will never lose sight of their predicament, even as I would never counsel that any of them try to make up for lost time by gambling on a short-term, high-risk investment in the emerging markets. Nevertheless, I believe investors are better off to preserve their patience and a sense of perspective.

Time and perspective are two of the most valuable tools that investors can possess (along with financial acumen). Perspective allows investors to put events in context, to frame decisions with data and facts, and to de-emphasize emotion and bias. Time allows sufficient room for careful decisions to operate as intended, usually for the better. Both are luxuries within the financial world, always in short supply.

Yet both are essential now: a great deal of change is taking place in the emerging markets; but the change is incremental and difficult to perceive. That difficulty is heightened by the modern world in which we live. Anyone modestly exposed to mass-market financial media is bombarded with headlines about the paucity of growth in the developing world (true, but in reality it has been so for several years) and the fragility of emerging market currencies versus the dollar (ditto). We are inundated with data and information, yet we perceive most of it without the benefit of substantive analysis. The constant barrage places us under a perverse sort of pressure. We feel an imperative to profit by the abundance of data; we are goaded into churning our portfolios, chasing whatever is performing well today. To do otherwise constitutes a type of negligence, a failure to safeguard our financial security.

This sort of data-rich / analysis-poor environment is the anathema of a disciplined investor. It impedes any sense of perspective or scale; it undermines patience. It also poses special challenges for the emerging market investor. While financial success is judged instantly, economic development unfolds slowly, in fits and starts. By definition, the emerging markets are situated in a basic state of development; investors seek to capitalize on their progress over time. Yet most of the advances that spur such progress are nearly imperceptible, frustratingly complex, and slow in gestation. So it has been this year in the developing world. Headlines have centered on slowing economies, frail currencies, distressed commodity markets, and riots in the streets. The resulting clamor masks the change that is underway.

A Change in the Model

As discussed at the outset of this letter, there are many reasons why emerging markets have struggled this year; but the most important of these is the paucity of growth. Certainly, there are a handful of smaller markets that seem to be expanding rapidly. Yet apart from these peripheral countries, the developing world is no longer growing as fast as it once did. In evidence of the deceleration, the International Monetary Federation (IMF) recently downgraded its 2013 growth forecast for the developing world to 4.5%.² This was 0.5% lower than the original forecast; but more importantly, it signaled the slowest expansion in over a decade (except for the period immediately following the global financial crisis). The IMF cited “bottlenecks” in infrastructure, labor markets, and investment as reasons for the decline.³

I agree that “bottlenecks” are the proximate cause for the deceleration, but I go further still: the real reason that growth has slowed is because the economic model that spurred development is beginning to approach its natural limits. The developing world has realized a great deal of growth over the past two decades because successful countries chose (to varying degrees) to de-regulate their markets and open themselves to trade, competition and investment. In the process, such countries relied on an economic model that was either extraction-based (i.e., mining or cultivating natural resources) or manufacturing-based (i.e., export-oriented production). We all know the subsequent story: the emerging markets pulled themselves out of the depths of poverty by either making stuff, or by pulling stuff out of the ground, and then selling it to the rest of the world. Yet today, that economic model is constrained. Trade flows are highly integrated around the world; while further integration is certainly possible, the marginal benefit from doing so is likely in decline. Meanwhile, developing countries have realized substantial gains in their living standards; an export-oriented growth model that relies on cheap inputs, cheap capital, and cheap labor is increasingly outmoded and unviable. If the emerging markets are to expand at a rate anything near their former pace, the economic model must change.

What You See Is All There Is

Fortunately, I can attest that Seafarer’s research indicates important changes are underway. In brief: the emerging markets have begun to transition from an economic model that is highly dependent on external demand (i.e., exporting resources and manufactured goods) to one that emphasizes internal demand (domestic consumption, and especially domestic services). The transition is a complex one, and I have discussed it in other commentaries available on this website,⁴ so I won’t revisit it here.

Instead, I will discuss how difficult it is for most investors to observe the subtleties of the current transition. The shift from an export-oriented model to a domestic one does not occur quickly; it rarely makes headlines, and the gradual nature of transition means it does not suddenly dominate economic statistics. Yet change is taking place across much of the developing world. Even China, famous for its export-led growth, is shifting toward a new model.

Over the past decade, China’s tertiary (domestic services) sector has grown substantially faster than both the primary sector (agriculture and resources) and the secondary sector (manufacturing and construction). At the end of 2012, services already represented roughly 44% of the country’s total economic output. If the sector’s growth continues a few more years, services will soon eclipse manufacturing as the largest component of the Chinese economy.⁵ Yet China’s service-centric future is contrary to predominant economic narratives about the country, which emphasize the importance of the manufacturing and construction sectors. The challenge is for investors to possess sufficient time and perspective to observe the transition at work, rather than rely on outdated narratives.

That challenge is heightened in the context of stock markets. Within the developed world, investors routinely rely upon stock indices to convey information about the underlying market’s scale, performance and change. However, in the emerging markets, the prevailing benchmark indices are designed in a manner that does not capture structural change very well.

At a fundamental level, stock indices are supposed to serve two main functions: they are meant to represent the breadth and depth of a given market, and to measure that market’s performance. Unfortunately, indices for the emerging market are drawn up in a manner that subordinates these two classic objectives. They emphasize liquidity and scalability in place of representation and measurement.⁶ The upshot of this is that the indices might fail to pick up on the subtle shifts in an economy. Prevailing indices place special emphasis on liquid, scalable, large-capitalization companies; these are the same companies that were responsible for the historical growth of the emerging markets (i.e., resources, manufacturing, exports), and they are not necessarily the same ones that represent the future (consumption and services).

In his book Thinking, Fast and Slow, the eminent behavioral scientist Daniel Kahneman introduces a concept called “WYSIATI.” The acronym stands for “what you see is all there is.”⁷ WYSIATI refers to a fallacy of perception, whereby human beings naturally assume that what they initially see or perceive is all that matters. WYSIATI impairs judgment: it means that decisions are based on inadequate data, and conclusions are developed without sufficient context.

I think WYSIATI is inherent to some investors’ understanding of the prevailing benchmark indices. By design, such indices exclude a large portion of the market capitalization associated with the emerging markets. Yet those investors assume, based on WYSIATI, that the indices offer an unbiased representation of the depth and breadth of the market. The data suggest otherwise. The following table presents the portion of market capitalization that a major index⁸ purports to measure, versus Seafarer’s estimates of total, unadjusted capitalization.

As is evident in the table, the index represents only 33% of the estimated total capitalization present in the developing world. Perhaps more importantly, the index captures only 30% of the category entitled “Domestic Services + Non-Bank Financial Services + Consumption” – the very category where I believe the greatest structural change is taking place, and which (arguably) represents the future of the developing world. The index is somewhat more representative of the other three categories; yet these three (arguably) represent the emerging markets’ past and not their future.

In conclusion, WYSIATI poses a serious challenge to the emerging market investor – especially right now, at a time of structural change. The current economic transition is too slow and subtle to be obvious. Meanwhile, any spillover effect on stocks may be partially (or wholly) obscured by the index; the industries at the forefront of transition might not receive adequate representation, at least not at the present time. I think investors must lean heavily on their most useful tools – time and perspective – if they wish to overcome the WYSIATI fallacy. Doing so will not be easy: it will require persistence and patience, sometimes in the face of disappointing returns. Seafarer is up for the challenge.

Thank you for entrusting us with your capital. We are honored to act as your investment adviser.

The performance data quoted represents past performance and does not guarantee future results. Future returns may be lower or higher. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than the original cost. View the Fund’s most recent month-end performance.

The MSCI Emerging Markets Total Return Index, Standard (Large+Mid Cap) Core, Gross (dividends reinvested), USD is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. Index code: GDUEEGF. It is not possible to invest directly in this or any index.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

1. The Fund’s inception date is February 15, 2012.
2. IMF, “Global Growth Patterns Shifting, Says IMF WEO,” 8 October 2013.
3. IMF, “Global Growth Patterns Shifting, Says IMF WEO,” 8 October 2013.
4. See, for example, the Letter to Shareholders dated November 12, 2012.
5. National Bureau of Statistics of China.
6. MSCI Barra acknowledges that its indices place “a strong emphasis on investability” [whether a security can be purchased by a foreign investor without impediment] “and replicability” [whether a security can be purchased in large quantities] “through the use of size and liquidity screens.” Please see: MSCI Barra, “MSCI Global Investable Market Indices Methodology,” May 2013, page 10.
7. Daniel Kahneman, Thinking, Fast and Slow (2013), chapter 7, page 84.
8. The MSCI Standard Emerging Markets Index.