The benefit of diversification continues to be brought home to those funds which invested so heavily in equities in the developed markets in the 1990s. The myth that such an investment could deliver great performance year after year has been cruelly exposed. We learnt as early as 1994/95 that emerging markets which were then touted as a reliable out-performer were not always going to be a profitable place to invest.
In fact, year-on-year, under-performance lasted a full five years and it was not until 1999 before the average emerging market investment beat an investment in the developed markets. As most pension funds did quite well out of their developed market equities in 1999 anyway, this outperformance was largely overlooked. In actual fact the cumulative under-performance in the mid 1990s was truly staggering. For example, between September 1994 and August 1998, whilst the S&P500 gained 107%, the MSCI Free Global Emerging Market Index lost 58%.
Unfortunately, the five lean years in emerging markets meant that most investors simply decided to ignore the sector altogether.
This was, of course, unfortunate. Emerging markets provided relative out-performance in 2001 and 2002. This is not of course to say most investors made money in the sector. They did not, but many, at least, lost less than in the developed markets. However, the past is past and although GDP growth in the developing countries has consistently outpaced GDP growth in developed countries, it is future prospects that matter. So what can investors in emerging markets expect? Will we continue to see GDP growth differentials in favour of emerging markets?
Many commentators are currently very positive about prospects. The long term strategic case has always attracted me but is there also a convincing tactical case. Well, relative valuations appear attractive; the price earning ratio is certainly reasonable, the yield looks good and price to book is relatively low.
Examining the detail of the strategic case is also impressive. It appears to be stronger than ever. There continues to be a real expectation of sustained economic growth. Although it is extremely difficult to generalise as emerging markets are quite diverse, a number of factors have become apparent and are all in favour of an investment in emerging markets as a whole.

There is the deregulation or privatisation of key industries combined with the introduction of fiscal prudence with tight fiscal and monetary policies. The reduction of price subsidies and trade barriers has encouraged enhanced international competitiveness. Exchange rates appeared to have stabilised and inflation generally brought under control. Increased resources seem to be available to the private sector with a decreasing foreign debt burden. However, the biggest factor for me has been the demographic argument with an expanding consumer base and an increasingly more skilled and competitive labour force.
But what about the risks: Clearly it is important to consider to what extent high potential returns are tempered by the inherent risks.
Obviously there are likely to be greater currency risks but investors in emerging market bonds must also consider the potential for defaulting sovereign loans as many emerging nations continue to have heavy indebtedness. There is a greater potential for political uncertainty in developing nations and just how much can investors rely on fundamental data and research information. Many emerging markets have non-standard or lower disclosure requirements and there are certainly governance difficulties and limited remedies in the event of default.
Clearly, just as in developed markets, pension funds should ensure proper portfolio diversification however, there are strong arguments in favour of an active approach to emerging market investment, whether in equity or bonds. I was very impressed by arguments recently put forward by Antoine van Agtmael the CIO of Emerging Markets Management LLC. Agtmael has noted that over the past five years only one-third of the companies that were in constituents of a MSCI emerging market index at the start remained in the index by the end of the period and that there are as many new companies in the index as there are ‘survivors’. Agtmael cites lack of liquidity, mergers, bankruptcies, de-listings and restructurings as the main reasons and concludes that index-driven investing or a simple focus on the largest market cap stocks just does not pay.

A good case can be therefore be made for the inclusion of small cap stocks in an emerging market portfolio as even a small – but overweight – allocation has, and therefore could again, add value over time. A strong argument in favour of this is the fact that over the last few years many of the current market leaders were, only a few years ago, small, unknown companies that became big. There is probably a lack of research coverage creating the potential for discovery through careful, independent analysis.
Although many funds consider their biggest problem is picking the winning managers, actually the most important issue is getting the asset allocation right in the first place. This is likely to provide the bulk of future performance but will pension funds be brave enough to increase their exposure to emerging markets?