Today, emerging economies contribute to over 50% of world GDP growth and this trend is only set to continue for the foreseeable future. The increased significance of the emerging markets to global growth, underpinned by domestic demand driven growth and robust fundamentals, has led institutional investors to increasingly regard emerging markets as a strategic rather than a tactical asset class...
Allan Conway, Head of Emerging Market Equities
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This shift in investor perception, which has been reflected by record inflows of over $95 billion into emerging markets equity in 2010, has led to a debate about the best method for investors to gain exposure to the emerging markets. This paper addresses some of the issues.
Myth 1: Investing in developed companies carrying out business in the emerging markets is better than investing in emerging markets companies directly. Developed market companies are increasingly looking to the emerging markets to secure future growth, and corporates in many developed economies are generating an increasing proportion of their revenue from the emerging world, from around 9% in 1990 to almost 20% today, as highlighted in Chart 1.
Investment in emerging economies by companies in the developed world is a growing trend, as illustrated in Chart 2. This is expected to continue as many multinationals are becoming reliant on emerging markets growth to generate revenue. For example, Unilever currently generates over half of its sales in the emerging markets, and Nestlé almost a third.
As a result of these trends, an investment in many developed markets stocks today is often an implicit investment in emerging economies and indeed some investors rely on this indirect route to gain Emerging Markets exposure. However, such an approach means investors are still investing in companies with 50% or more of their income from developed markets. Not only does this dilute the investment, but investors may also pay a premium for developed companies’ operations in the rest of the world.
The weakness of this implicit approach is also reflected in performance returns. Goldman Sachs have produced a BRICs Nifty 50 Developed Markets Index which comprises 50 companies from the developed markets that are believed to directly benefit from strong growth in the emerging markets and, in particular, the BRIC economies. The median exposure to emerging markets, as defined as a percentage of operating profit or sales, is 29% for the 50 selected companies. However, as highlighted in Chart 4 below, while the BRICs Nifty 50 Developed markets Index has modestly outperformed the S&P 500 over the past five years, the index has significantly underperformed the MSCI Emerging Markets Index.
FTSE has similarly created a developed multinationals index which includes multinationals that derive 30 per cent or more of revenues from outside their home economic region. The FTSE Developed Multinational Index has returned 32% over a 10-year period to 31 May 2011, while the MSCI Emerging Markets Index has returned 264%, as shown in Chart 4 below.
Investors have also justified gaining exposure to emerging markets through an investment in developed companies by suggesting it mitigates the perceived higher risk of emerging markets. While by their nature developing economies are undergoing structural change which can lead to increased market volatility, we believe emerging economies today represent something of a safe haven, with low sovereign, corporate and household debt levels, high savings rates, large current account balances and huge foreign currency reserves. This is in contrast to the debt-ladened developed world. This shift in fundamentals between the emerging and developed world has taken place since the 1990s, as illustrated in Chart 5 below, but has only been highlighted to investors by the recent global financial crisis. The chart clearly shows that ‘stress’ in the developed world is much higher than in Emerging Markets, where the trend has been declining for over 20 years. Moreover, an implicit investment in emerging markets via developed companies will not eliminate these perceived higher risks. This was highlighted recently by BP’s failed attempt to partner Russian energy giant Rosneft, owing to AAR (a consortium of Russian billionaires who control half of the TNK-BP venture) blocking the deal.
As such, we believe, that the best way of gaining exposure to the emerging economies is by investing directly in
emerging stocks rather than indirectly through developed companies.
Myth 2: Giving global equity managers the discretion to invest in emerging stocks is sufficient to gain exposure, rather than allocating to specialist emerging markets managers. As highlighted above, developed companies are becoming increasingly reliant on emerging markets growth to generate profit. Similarly, ‘international’ and ‘global’ equity managers are also increasingly relying on emerging markets equity exposure to a greater extent in order to generate portfolio returns. Developed managers are accessing emerging economic growth implicitly through investment in developed companies but also through direct investments in emerging markets themselves. The average ACWI ex-US manager had over 20% invested in emerging markets in the first quarter of 2011 (Source: Intersec) and often the key determinant of their competitive performance is their exposure to emerging markets.
Such an approach ignores the importance of specialist knowledge of political, macro-economic and currency factors which have a major influence on the performance of companies. Moreover, regulations and governance, although improving, are not as comprehensive as in developed countries. All of which means that fund managers are required to understand a diverse range of emerging markets factors in order to consistently generate alpha.
Furthermore, on a risk-adjusted basis, specialist emerging markets equity managers have also been shown to deliver a superior information ratio (Chart 7). Indeed, EAFE plus and ACWI ex-US managers actually have a flat and negative information ratio, respectively, in emerging markets.
The importance of local specialist knowledge is reflected in the performance and risk characteristics of the portfolios of specialist emerging markets equity managers compared to the emerging markets component within EAFE plus and ACWI ex-US managers’ portfolios. As illustrated in Chart 6, specialist emerging markets equity managers have consistently achieved significantly higher returns on average in comparison to EAFE plus and ACWI ex-US managers.
This highlights the benefit of enhanced diversification and increased resources dedicated to researching the markets, together with a superior ability to harness the best opportunities in the markets.
In this context, another useful measure is the batting average. Effectively, the percentage of time that managers under/outperform relative to the index over rolling three-year periods. As can be seen from the three graphs below, only specialist emerging markets managers have achieved a batting average above 50.
Myth 3: It is better to invest in individual country and regional funds rather than a global emerging markets fund.
Investors choosing to invest with dedicated emerging markets equity specialists are still facing three further choices: whether to gain exposure by investing in global emerging markets funds, regional funds or individual country funds. The most suitable vehicle will depend to a certain extent on the investor’s internal resources and capabilities. However, a number of general points can be made based on the positives and negatives of the three main strategies.
There are a number of benefits for investors who adopt a global emerging markets (GEMs) approach. In particular, when adopting a GEMs approach, getting the country decision right is extremely important. As can be seen from Chart 9, the country factor, historically, has been far more important than industry or style factors. In other words, when looking at say a Brazilian bank versus a Turkish bank, the country they are operating in is more important than the fact that they are both banks. The exception to this is of course commodity stocks where global factors apply.
Generally, a global emerging markets approach brings significant diversification benefits. As the efficient frontier charts below clearly demonstrate, the trade off between risk and reward is typically much more attractive if a GEM approach is adopted.
Taking money out of the EMEA or Asian region and investing in GEMs reduces risk and increases return.
Taking money out of GEMs and investing in Latin emerging markets does increase risk, but significantly increases return.
Similarly, countries in one region may be more correlated with countries in another region versus those in the same region. For example, Russia is more correlated with Brazil than it is with Poland. Thus a regional approach may also be inappropriate. Each country must be looked at separately. Chart 11 clearly shows this dispersion within regions.
Although a country approach provides the most control over asset allocation and exposure can be fine tuned accordingly, investing in single country funds is an even higher risk and can be costly, not just in terms of hiring internal expertise, but also in terms of managing the strategy.
Investing with a GEM manager who is constantly monitoring and investing in the widest range of opportunities should result in lower risk and significantly higher returns.
A GEM approach is also likely to be the cheapest and most efficient option for the end investor. Typically the investor would need to allocate fewer investment professionals to the Emerging Markets asset class, as there is likely to be a smaller number of external managers to assess and monitor.
There are relatively few negatives for investors adopting a GEM approach. The main negative is that the investor has less control in terms of maintaining any desired structural overweight or underweight positions to particular regions or
countries if they only use this approach.
Although combining a global approach with a regional or country strategy can solve this to a certain extent, it also introduces an additional level of complexity in terms of monitoring net exposure to each region and country. The cost of managing the assets and monitoring the external managers will also increase.
Thus, we would contend that adopting a GEM approach rather than investing in individual countries and regions, should produce a much better profile of risk-adjusted returns.
Myth 4: Emerging markets debt is a better way to gain exposure than through emerging markets equity.
Interest in emerging markets debt (EMD) has been strong owing to the robust economic fundamentals of the emerging world, with limited need for balance sheet repair (in stark contrast to the developed world); together with the attraction of higher yielding returns in a global environment – characterised by loose monetary policy and near zero interest rates.
The strong improvement in economic fundamentals has led to a major re-rating of emerging sovereign debt. Spreads relative to developed debt have narrowed significantly, as can be seen on Chart 12. The spread on the Emerging Market Bond Index global sovereign has fallen from over 1100 basis points at the end of 1998 to around 300 basis points today. In contrast, the iTraxx Sovereign Index for Western European CDS has been trending up on the back of continued developed sovereign debt concerns.
Furthermore, certain emerging countries are judged to be less risky borrowers than several western countries, with recent sovereign debt issues yielding less than similar maturity euro-denominated debt of peripheral European countries, including Spain.
Thus, while emerging debt has undergone a major re-rating over the last 10-15 years, emerging markets equities have
not yet been re-valued to reflect the improved fundamentals, and still appear attractively valued.
Myth 5: Investing in emerging markets through ETFs is better than investing with traditional active managers.
For a more comprehensive review of this topic, please refer to a Talking Point paper entitled ‘Active versus Passive’, published by the Emerging Markets Equity team in May 2010. We provide a summary of the findings below:
– Equity markets are not efficient and GEMs are much less efficient than developed markets.
– By using a passive approach investors are foregoing the opportunity of capturing pricing anomalies and locking themselves into momentum investing.
– GEM ETFs are not that cheap. The average Total Expense Ratio (TER) is 79 basis points. In addition, ETFs have
underperformed their country indices, on average, by 27 basis points over the past five years. Thus, investors are likely to find themselves, on average, 106 basis points below the index in any given year.
– On a gross basis, the average active GEM manager has outperformed the index in eight of the last 10 calendar years. The average GEM ETF has only outperformed in four of the last eight calendar years. (Source: Morningstar)
How best to gain exposure to the emerging markets is ultimately a function of an investors’ risk preference and risk tolerance, together with an investor’s internal resources and capabilities. However, we believe the analysis above supports the following conclusions:
1) The strength of the investment case for emerging markets, in itself, warrants an explicit allocation, rather than an implicit and diluted investment through developed companies.
2) It makes sense to allocate to specialist emerging markets equity managers who, on average, have been shown to consistently outperform the emerging markets component of ‘international’ and ‘global’ equity managers.
3) Investing in global emerging market funds, at least for core exposure, should yield lower risk and better risk-adjusted returns than investing in single country or regional funds.
4) While emerging debt has undergone a major re-rating over recent years, emerging equity has yet to re-rate, and still appears attractively valued.
5) Passive investors will forego the opportunity of capturing price anomalies in inefficient emerging markets. Active emerging market managers have, on average, outperformed the MSCI Emerging Markets Index; whereas passive managers (allowing for tracking error and costs) have underperformed.
The views and opinions contained herein are those of Azad Zangana, European economist, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisers only. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored.
Source: ETFWorld – Schroders