Emerging markets - too big to ignore
In our view, emerging market equity is an asset class that has ‘grown up' from its volatile past. Our contention is that investors seeking a truly diversified portfolio should include exposure to emerging markets. They are simply too big and dynamic for investors to ignore.
In our quantitative analysis, we have found that measurable risk and volatility have declined in emerging markets over the past 10 years, providing attractive long-term risk/return characteristics and a valuable source of diversification for global equity portfolios.
Active managers have long played the dominant role in managing emerging-market portfolios, and many investors regard such managers as the de facto "experts" for this asset class. However, we encourage investors to take a multi-strategy approach to emerging market investment and to seek an optimal mix of these strategies.
As emerging markets continue to evolve, investors seeking higher long-term returns should not delay an implementation of emerging market exposure regardless of their choice of investment approach.
The median active emerging markets manager outperformed the MSCI Emerging Markets benchmark by about 200 basis points (bps) during the five years to June 2006. During this five-year period, emerging markets returned more than 20% annually, regardless of whether exposure to these markets was sourced through active management, quantitative approaches or index-based strategies. This return rate is more than double that of a purely developed-country international strategy based on the MSCI EAFE Index during the same period. Similarly, US equity strategies tracking either the broad S&P 500 or the considerably riskier small-cap strategy of the Russell 2000 offered returns in the single digits.
Dynamic macro- and microeconomic advances occurring in emerging-market countries stem from the serious structural reforms implemented since the various crises of the 1990s. Chief among these reforms are:
n Foreign currency-denominated debt reduction (mostly US dollar-denominated) to 10% of GDP currently from 90% in 1999 for emerging-market countries, in aggregate;
n Reduction of fiscal deficits and creation of surpluses, in aggregate;
n Growth of current account surpluses away from historical deficits in many major developing countries;
n Reduction of inflation or hyper-inflation to single-digit levels in almost every market;
n Greater transparency at government and corporate-governance practices, with more emerging market companies moving to the Generally Accepted Accounting Principles (GAAP)
standards used in the US.
Our contention is that any investor who has or is considering international equities exposure should consider the best way to obtain return and diversification. In our opinion, the underlying qualities and positive developments occurring within emerging markets make a compelling case for including them in a long-term portfolio. Some factors contributing to this view follow:
n Emerging markets and the countries in which they are domiciled are too significant to ignore - geographically, demographically and economically. They comprise 90% of the world's land mass, including some of its most valuable real estate; they constitute 85% of the world's population; and they generate 48% of global economic output.
n Even with the 2005-06 surge in oil and energy prices and the global rise in interest rates, emerging market economies are projected to grow at approximately 6.2% this year - more than double the growth estimated for developed countries - with implied benefits for company earnings.
n Demographic trends in developing countries are likely to contribute to further productivity gains. By contrast with the population decline occurring in many developed countries (eg, Japan, Italy and Belgium), the population of many developing-market countries is increasing. Developing countries also stand to gain from the likelihood that more women will enter the labour force and that more workers will leave agriculture for higher value-added work.
n Some of the world's fastest-growing, and possibly best-managed, industry-leading companies are headquartered in emerging market countries. South Korea's Samsung, for example, is now a home-electronics leader boasting a market capitalisation of nearly US$80bn.
Empirical evidence shows that portfolio risk in the emerging markets asset class declined over the past decade. This translates into more sustainable returns that lend greater credibility to comparing the valuations of developed and emerging markets. Some analysts argue that the increasing correlation between the equity performance of emerging and US markets during the past decade has diminished the diversification benefit of exposure to the developing asset class. However, lower volatility has accompanied the higher correlation, thereby reducing marginal risk.
A number of factors can explain higher correlations between markets:
n Global equity markets moved in closer sync during both the expansion of the technology bubble in the late 1990s and its collapse early this decade;
n Government and corporate reforms in emerging markets followed the economic and financial crises of the 1990s. Because these reforms are cumulative and sustainable, we believe they help lower systemic risk and enable emerging-market equities to behave more like their counterparts in developed countries;
n Globalisation - the integration of economic activity resulting from stronger trade ties and more companies with greater international operations - also has helped increase correlations as compared against those of the early 1990s.
Despite this 10-year trend, correlations actually fell during the first half of 2006. And the correlation over the past 14 years between the MSCI Emerging Markets Index (EM) and the S&P 500 is still only 63%. Thus, even after the powerful four-year rally in emerging markets since autumn 2002, the asset class offers valuable diversification benefits.
The most important decision an international investor can make is to give emerging markets adequate allocation relative to their weight in the overall global equities markets. To gain effective exposure to this dynamic area of the international equities asset class, an investor can - and should - use multiple approaches, with an overall objective of achieving the optimal allocation and exposure to emerging markets. Beyond using an appropriate policy benchmark (and holding active managers accountable to that benchmark), investors should consider using an index-based approach to represent their core allocation to international equities, including emerging markets.
An investor seeking to achieve developed and emerging market exposure through a single allocation can use an integrated international index strategy (eg, the MSCI ACWI ex-US, the FTSE All World ex-US, the S&P/Citigroup Global ex-US or the recently introduced international benchmarks from Dow Jones Wilshire or Russell indexes) to benefit from emerging-market countries that graduate to the developed-country status.
In the current decade, emerging markets have once again become the darling of investors, soaring by 179% from September 2002 to June 2006 in US dollar terms. During the same period, the S&P 500 index rose 49% and EAFE rose 101% (see Chart 1).
The strong, but occasionally volatile, performance of emerging markets over the past 18 years has spawned a variety of myths and misconceptions in the financial community, including:
n "Emerging markets have great returns for a while, but in down markets, they don't just decline, they collapse. It's impossible to get the timing right."
n "There's too much noise from politics, regulatory irregularities and unpredictable management - if you're not an insider, you'll never win at this game."
n "They're a great play when the US economy is booming and when commodities are hot. But forget about them in a downturn."
n "You must pay an active manager high fees to run emerging markets portfolios, because they're the only ones who can handle all of the challenges and beat the market."
n "Beware of the contagion effect. When Thailand gets a cold, Brazil contracts pneumonia."
We are not suggesting that all of the past troubles characterising emerging markets are permanently behind us. As innovative as they might be, pharmaceutical companies have yet to develop cures for greed and fear. But a look at macroeconomic reforms provides useful perspective on how the extreme boom-bust periods of the past may become less severe in the future. As a result of these developments, we are comfortable in declaring the growing maturity of both emerging stock markets and emerging markets investors a genuine "paradigm shift," one which the pioneers of emerging market equity investing at the World Bank's International Finance Corporation could only have dreamed of.
The major country risk and bond rating agencies are decisively recognising the improvements occurring throughout emerging markets. Standard & Poor's raised its long-term foreign currency sovereign credit rating for China to A in July 2006 with a stable outlook from A- to reflect "China's persistent efforts to strengthen the banking sector to reduce the future fiscal burden" as well as its "continuing economic liberalisation and reform." Fitch upgraded its foreign currency sovereign rating for India in autumn 2006 by one notch to BBB- from BB+, citing fiscal consolidation and progress on structural reforms.
Improved overall sovereign risk ratings in the emerging markets asset class is most clearly reflected in the dramatic decline of sovereign bond spreads over the past eight years (see Chart 2).
Because sovereign bond spreads are a good proxy for perceived country risk, the improved financial stability of many emerging market countries holds positive implications for future equity performance.
Spreads have been low and stable for most of 2006, reaching an all-time low of 178bps in April. They remained around 200bps for most of the year, and were steadily below 200bps during June, July, August and September.
Although it would be imprudent to disregard the potential for adverse changes in these or any other markets, we believe that bond spreads are unlikely to widen in the near term for the following reasons:
n The US Federal Reserve is likely to leave the federal funds rate unchanged for quite some time, diminishing any further rising interest rate pressure on dollar-denominated corporate or government debt within emerging markets. As we noted earlier, developing country debt denominated in foreign currencies has been dramatically reduced to only about 10% of overall emerging market GDP from about 90% as recently as 1999;
n Economic growth in Europe and Japan should be even stronger in the second half of 2006 than the first as well as for 2007. In September, the IMF issued its World Economic Outlook, forecasting global economic growth of 5% for 2006 and 2007 - largely because of steady growth in China and other developing countries;
n Continued robust demand from China and India, in particular, should continue to keep commodities prices at relatively high levels. Considering the effects of a slight US slowdown, however, commodities prices are not likely to retrace their peaks reached earlier in 2006;
n None of the largest emerging market countries face any major debt repayment pressure, as in the past, particularly given the overall current account in surplus for the group. In fact, we expect a continuing gradual trend of country sovereign risk upgrading in the coming years.
Developing economies contribute nearly half of the world economic activity and are growing at double the rate of developed-country economies. For international equity portfolios, this observation provides the most fundamental argument for allocating to emerging markets equities.
The sources of growth-sustaining global output over the next several years are not limited to the economic recoveries of Europe and Japan. Emerging markets themselves contribute to an increasingly significant portion of such output. The economic rise of China and India shows no immediate signs of slowing, providing plenty of continued strong demand for commodities exported by many emerging markets (eg, iron ore from Brazil, copper from Chile).
The bull market in commodities - related to strong global economic growth - has undoubtedly been a crucial factor supporting emerging market equities over the past few years, particularly for those countries that are net exporters of commodities. And while there is heated debate among market analysts over how long oil, copper and gold, for example, can stay at such high levels, there is compelling evidence that demand for commodities in China and India should remain strong to support the demand for export-driven manufacturing output and to satisfy other increases in their respective domestic demand for commodities.
For a sense of the role China alone has been playing in contributing to global demand for commodities, consider the following figures from the Bank for International Settlement (BIS). In 2005, China accounted for more than 57% of the incremental demand for aluminum, 60% of demand for copper and 30% of demand for oil. These figures are likely to remain constant in 2006. The continued strength of global economic output - 5% this year and next as forecast by the IMF - reduces the likelihood of a sharp, rapid downturn in commodities prices. And the BIS sees no signs of real economic growth slowing in China and India from their recent 8-10% annual rates.
The emergence of a middle class in countries like Brazil, China, India and Russia, in particular, has meant that consumption is contributing a greater portion of GDP than in the past. Domestic value-added service industries are in their infancy in many cases. The home finance industry, for example, is only beginning in the majority of larger developing countries.
This is not to suggest that all is rosy for emerging-market countries. Low-income oil importers, for example, have only recently begun to feel the squeeze of high oil prices and remain vulnerable to future spikes. Crushing poverty is still pervasive. Inadequate health care, lack of widespread education and limited access to basic services are still problems in much of the developing world. Despite these deficiencies, several factors contribute to our long-term optimism:
n The gradual emergence of technology, which has already led to greater gains in productivity in some countries (eg, Brazil, China and India);
n The migration of an increasing number of workers from agricultural business to higher value-added sectors; and
n Increases in the number of working women.
In a reflection of this maturity, the weight of emerging markets within the total world equity market as measured by MSCI All Country World Index (ACWI) has risen from below 4% in late 2002 to just over 7% currently.
In a recent report, the Credit Suisse emerging markets research team makes the case that global equity funds are favouring emerging markets as a core long position - as opposed to their past behavior, when they bought emerging market equities in sync with accelerating global leading indicators or, conversely, were sellers when such indicators were declining. Using data from Emerging Portfolio Fund Research, Credit Suisse calculates that the average weighting for emerging markets within a global fund (including the US) has risen from slightly below 5% in early 2003 to around 8% as of August 2006.
Index providers vary in how they define the emerging markets universe considered investable. For example, after selecting 25 emerging market countries and adjusting for free float, MSCI calculates the investable portion of that total $7.1trn at about $1.9trn, or 7.5% of total world investable market capitalisation. Without the free-float adjustment, MSCI calculates the total market capitalisation of the emerging markets universe at $4.4trn. That is still $2.7trn less than the Standard & Poor's definition.
Indexing and active management are not mutually exclusive; in fact, they can complement each other. An index-based approach can provide the efficient, low-cost core exposure as the anchor for a larger emerging markets allocation, including an allocation to active strategies. Around this core, the investor has the option to:
n Add regional specialist managers, or simply overweight a region;
n Use traditional or quantitative active managers that are expected to add value through stock selection;
n Add private equity in emerging markets;
n Include a ‘structured' or ‘alternatively-weighted index' strategy;
n Add managers that specialise in ‘frontier' markets beyond the more ‘investable' core;
n Tilt toward a management style such as a deep-value orientation; or
n Add an investment vehicle that follows a long/short strategy (eg, a 130/30 programme) or a market-neutral strategy.
Indexing can also provide investors with effective market exposure as they seek or evaluate active managers. Once a successful manager is identified, his/her addition should improve the risk/return characteristics of the overall portfolio thanks to added diversification and potential to generate higher returns. But this begs a question: how much of the performance improvement is generated by the manager's skill and how much is due to the beta of the overall asset class itself? While the median active manager did have slightly better performance than the index before fees it is the beta of the asset class that was significantly higher than developed markets, and thus the larger contributor to the portfolio.
Finally, it should be noted that indexing in emerging markets is no longer an untested approach. Since the launch of the first emerging markets index funds in the early 1990s, cost-effective, emerging market indexation is available from at least six global index-based management firms in a variety of global, regional and single-country vehicles. In fact, since the IFC's $42m launch of the first global emerging markets index fund in 1993, emerging markets index assets have increased more than a thousand-fold, with total indexed assets exceeding $50bn as of September 2006.
No matter the choice of the investment approach - whether active, structured or index-based, the investor seeking higher returns should not wait to gain exposure to emerging markets. The expected return and diversification benefits are too great. Chart 3 shows both strategies landed the investor in the sweet spot in terms of return. Emerging markets produced more than double the return of a purely developed international strategy tracking the MSCI EAFE Index. US strategies tracking either the broad S&P 500 or the considerably riskier small cap strategy of the Russell 2000 offered returns in the single digits. While it is true that the risk exposure increases, the higher historic returns justify this greater allocation of the risk budget.
We believe that investors should aim for a minimum core emerging market allocation that is close to its relative market cap in the international equity universe. This currently implies 12-14% of international equity or 7-8% of a global equity portfolio. A reader might be mistaken in thinking that one region's gain in share of growth detracts from another country's output. But economic growth is not a zero-sum game.
In fact, the opposite is true: the absolute size of the pie is getting bigger and bigger every year. Investors need to remember that expanding economic growth has brought - and will continue to bring with it - brand new companies, the creation of wealth in the form of earnings that never existed previously, new domestic investors within emerging markets and, naturally, returns for foreign investors in global markets.
Steven A Schoenfeld is chief investment officer and Alain Cubeles is senior investment strategist of the Global Quantitative Management Group at Northern Trust Global Investments