WHITE PAPER Emerging market equities does faster growth translate into higher returns? For professional investors - JUNE 2013

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1 WHITE PAPER Emerging market equities does faster growth translate into higher returns? For professional investors - JUNE 2013

2 2 - Emerging market equities does faster growth translate into higher returns? - June 2013 author Simon Godfrey, Investment Specialist - Emerging Markets Group Head. Research Director William De Vijlder, Chief Investment Officer, Strategy and Partners. Research Partners/ Contributors Raul Leote de Carvalho, Head of Quantitative Strategies and Research in the Financial Engineering team. Claire Méhu Head of Financial Engineering for Equities in the Financial Engineering team. Chris Jeffrey, Multi-Asset Solutions BNP Paribas Investment Partners UK Limited. Joost van Leenders, CFA charterholder Investment Specialist, Allocation & Strategy. BNP Paribas Investment Partners are the source of all data in this document as at end April 2013, unless otherwise stated.

3 3 - Emerging market equities does faster growth translate into higher returns? - June 2013 Contents Preface p. 4 Introduction p. 5 Emerging markets - an evolving universe Part I p.6 A detailed look at emerging market equities 1. Analysis of returns in emerging markets (EM) p. 6 a. EM equity returns : poster child for buy-and-hold Sidebar 1: the changing EM landscape b. What s in the price? An analysis of multiples and risk c. Diversification benefit decreasing? 2. The drivers of emerging market performance p. 10 a. What drives EM equity returns? Myths and reality b. Sensitivity of EMs to macro risk factors Sidebar 2: non-financial drivers in emerging markets Conclusion to Part I p. 14 Part II p.15 Introduction to Part II: How to extract value from the emerging market equity universe 3. Expected returns from EM equity as an asset class p. 16 a. Expected returns b. Currency hedging (are currencies a one-way bet?) 4. How to exploit the opportunity set p. 17 a. Diversification benefit within emerging markets b. Dispersion of returns (quantitative) c. What are the reasons for this dispersion (qualitative): Sidebar 1: Country case studies - China, Turkey, Brazil vs. Mexico and EM sub-categorisation 5. Quantitative approaches to active country allocation p. 22 a. Multi-factor model (Financial Engineering) b. Portfolio construction: Core/satellite allocation within emerging markets Sidebar 2: Challenges of the core/satellite allocation: description and results Conclusion to Part II p. 28

4 4 - Emerging market equities does faster growth translate into higher returns? - June 2013 Preface Investing in emerging market equities has been a source of diversification and returns for investors since the asset class came into being around 25 years ago. This investment theme has been so successful that investors have come to expect higher returns from emerging markets compared to developed markets whenever risk appetite is on the rise. This helps to understand why many investors have been disappointed by the recent underperformance of emerging equities, all the more so considering that emerging market economies continue to grow faster than those of developed countries. In this paper we analyse the drivers of emerging equity returns, look at the structural changes in these markets and assess the implications in terms of strategic portfolio allocation to the asset class.

5 5 - Emerging market equities does faster growth translate into higher returns? - June 2013 Introduction Emerging Markets an evolving universe Emerging market equity is a unique asset class in that an inevitable consequence of its success will be its eventual disappearance from the investment landscape: emerging becomes developed. This will take time of course and one would also expect that what is now called frontier will become mainstream emerging. This illustrates the dynamics of economic and financial development. This would also imply that the current underrepresentation of many countries in global benchmarks would make way for a weight whereby the market capitalisation is more in line with the economic importance of the countries. However, such a process will take considerable time. Recent trends have not played out in favour of the asset class. The period 2010-early 2013 marks a period of underperformance (compared to developed markets) of the group of countries we presently call emerging markets 1. After the Great Recession in , the investment case for emerging markets relative to developed markets, as well as on a standalone basis, seemed compelling: lower macroeconomic risks due to sounder economic policies and higher growth due to the efficiency with trends and technological advances. Nonetheless, emerging market equities as a group, have underperformed relative to developed markets. Within emerging markets, the BRIC countries have particularly underperformed. At the same time, smaller emerging markets have delivered great performance. This again illustrates to what extent investing in emerging market equities is a dynamic phenomenon. It is often said that for the long-term investor, the equity market is a weighing machine 2, which anticipates economic turning points and trends rather smartly, due to the efficiency with which new information is integrated into the price investors are willing to pay for shares. As we will see in the first part of our analysis, the long-term returns for investors in emerging market equities have been spectacular and have largely compensated the additional risk taken in financial terms. Whether they sufficiently reflect the growth characteristics of this group of countries and companies will be discussed in the second part of this paper. 1 For the equity investor, this group of countries includes the 22 included in the MSCI Emerging Markets index, though may also be taken more broadly as any country outside the countries classified as developed by MSCI 2 Paraphrasing Benjamin Graham

6 6 - Emerging market equities does faster growth translate into higher returns? - June 2013 Part I A detailed look at emerging market equities 1. Analysis of emerging market equity returns A. EM equity returns : stellar but volatile outperformance As shown in exhibit 1, from 1990 till 2012, an investment in the MSCI Emerging Markets price index hedged into USD would have obtained positive returns in over 70% (17/23) of calendar years which incidentally is about the same ratio as investing in global equities as a whole. It is worth noting nonetheless that the annualised return of this investment (20.1%) would have exceeded that of investing in the global developed market index of 5.2%. In other words, a buy-and-hold investor in emerging equities, hedging his currency risk would have made annualised gains four times that of investing in developed market stocks. (This ignores the costs of hedging currency risk, trading and other administrative costs, which it should be pointed out may be significant in emerging markets). On an unhedged basis, taking full local currency exposure, and translated into USD, we again see the advantage to emerging markets. Nonetheless, the investment would have provided positive returns in barely 55% (13/23) of calendar years, which is lower than the ratio of investing in global equities as a whole (16/23). The annualised return of this investment (8.4%) would have exceeded that of investing in the global developed market index of 5.7%. In other words, a buy-and-hold investor in emerging stocks would have made gains in excess of that of investing in developed market stocks, but would have increased their probability (with hindsight) of underperforming developed market stocks in any particular year. Local currency losses against the USD, especially in years from (Mexico, Russian default, Asian crisis) were severe. The situation reverses in the period onwards, where the unhedged returns in emerging markets are vastly superior at 12.6% in USD compared to a mere 0.7% in developed markets. These developments have caused a huge increase in the weight of the asset class in the MSCI All Countries World index moving from 1% at its outset in 1998 to 13% today although this remains only half that of their economies proportion of global GDP in USD terms 3. As we will discuss later on, one would expect that continued superior growth, high savings rates and increasing sophistication of local investors and capital markets will increase the weight of emerging markets in the global indices, including but not limited to a bigger role for today s frontier markets 4. 3 If measured on a purchasing power parity (PPP), this proportion is much higher, at around 55% (Source World Bank) 4 Defined as having lower market capitalisation and liquidity than emerging markets Exhibit 1: Annual returns of emerging and developed market equities in USD from January 1990 to December (50.00) (100.00) GEM World Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: BNP Paribas, MSCI, Factset April 2013 The changing EM landscape When analysing emerging markets in absolute and relative terms, it is worth pointing out that this is an extremely dynamic asset class in terms of its composition, reflecting its diversity and eventful 25-year history. We note three different phases in emerging market investing: The discovery phase : Characterised by abnormally high returns, this period coincides with greater internationalisation of portfolios, financial innovation as well as changes in the way development projects were financed. This period also saw the opening up of commodity markets due to geopolitical events (collapse of the Soviet Union). Crisis : a series of well-documented crises rocked the emerging markets universe (Mexico, Asian crisis, Russian default). The period is characterised by severe currency volatility as well as huge dispersion of country returns, immortalising the asset class reputation as a risky one. This period culminates in the TMT bubble and the subsequent deflation of equity markets globally. After the initial shock, undervalued emerging markets performed relatively well at the end of this period. The rise of China : Emerging markets outperform in almost every year (except 2008 and 2011). This period is the golden age of the BRIC countries, associated with rapid economic expansion in China, higher than average rates of growth and falling interest rates in India and Brazil respectively. Russia enacted deep structural reforms which resulted in an almost 5-fold increase in its stockmarkets from the trough in 1998 to the peak in As emerging economies recovered from the crisis and gained in stability, flows to emerging market assets grew significantly. From 10 countries in 1988, the composition of the MSCI Index has changed substantially over the years in line with the shifting fortunes of its members and their changing positions in the global economic hierarchy.

7 7 - Emerging market equities does faster growth translate into higher returns? - June 2013 Exhibit 2: Country breakdown (%) of the MSCI Emerging Markets Index Dec Dec Dec Dec Dec Dec-12 EM (Emerging markets) Argentina Brazil Chile China Colombia Czech Republic Egypt Greece Hungary India Indonesia Indonesia (Former) (Retired) Israel Jordan Korea Malaysia (Former) (Retired) Malaysia-EM Mexico Morocco Pakistan Peru Philippines Poland Portugal Russia South Africa Sri Lanka Taiwan Thailand Thailand (Former) (Retired) Turkey Venezuela Source: BNP Paribas, MSCI, Factset April 2013 The first observation is that the index is broad and diversified by country, with 22 economies represented, with clear differences in terms of size, economic drivers and political and market systems. This makes generalisations about emerging market equities tricky at best. In addition, there have been significant changes in its composition. At the index s inception, Malaysia (followed by Brazil and Thailand) was the largest weight it is now ranked in 9th place. China, the largest country in the index today at 18% (which is only counting the offshore-listed stocks) only joined the index in 1996 and became a significant weight in Greece, Israel and Portugal were still in the index at inception. On a sector basis as well, there have been numerous changes. At the outset of the index (we have sector data from 1994), there was a higher weight in Telecoms and Utilities stocks as these were growth areas in what were then economies at an early stage of development. There has been an increase however in areas such as Energy due to increased global demand over the last two decades, Information Technology, due to the integration of especially Asian manufacturers into global supply chains and advantages in outsourcing.

8 8 - Emerging market equities does faster growth translate into higher returns? - June 2013 Contrary to developed markets, the weight of Financials has increased in emerging markets as they were much less exposed to the global financial crisis and subject to tighter regulations after their own issues in the 1990s. Today, there is still a higher weighting in Financial and Resources stocks in the emerging market equity universe than in the developed markets universe this should be borne in mind when making comparisons based on performance or valuation. The next stage Not all emerging market economic activity is reflected in the MSCI index. This is due to large sections of the economy remaining under state control or in private hands (i.e. non-listed). The potential for further broadening of the opportunity set remains enormous. Linked to this, the comparison of total market capitalisation to GDP is favourable for emerging markets. Emerging market companies make of up 26% 5 of global equity market cap. Emerging markets represent 36% of global GDP (compared to 19% twenty B. What s in the price? An analysis of multiples and risk The price to earnings multiple paid by investors for exposure to emerging market equities has varied greatly over time. In this section we will try to understand how the P/E multiple for emerging market equities this has evolved in relation to that of developed market equities and how the risk profile emerging market equities has influenced returns. Importantly, we note that (with a slight exception in 2010) there has been a premium in earnings multiples for developed market equities, compared to emerging market equities on an aggregate basis 6 and also a noticeable convergence with developed market multiples over the course of the analysis. Exhibit 3: P/E multiples of emerging and developed market equities compared Dec.-95 Developed EM (Emerging Markets) Oct.-96 Aug.-97 Jun.-98 Apr.-99 Febr.-00 Dec.-00 Oct.-01 Aug.-02 Jun.-03 Apr.-04 Febr.-05 Source: BNP Paribas, MSCI, Factset April 2013 Secondly, we observe that there has been a downwards trend for both developed market and emerging market P/E multiples over the last two decades. In recent years the de-risking of pension funds and the death of equity (combined with increased demand for fixed income investments) has contributed to this process. Dec.-05 Oct.-06 Aug.-07 Jun.-08 Apr.-09 Febr.-10 Dec.-10 Oct.-11 Aug.-12 years ago). If GDP continues, as expected, to grow at a faster rate in emerging markets than in advanced economies, it will tend, over the long-term, to be reflected in a rise in GDP per capita. Rising levels of income increase the need for more sophisticated financial products and broadens the investor base (retirement plan and insurance investments should increase the stock market capitalisation). Even if we just include China, where due to capital controls only the stocks that are listed offshore in Hong Kong are included, the total market capitalisation would not be commensurate with the share of China in global output. Other countries market cap to GDP ratios are also unsustainably small; Russia, Indonesia, Turkey and Brazil have a total market capitalisation which is below their share in global GDP. In conclusion, we believe that the share of emerging markets within global equity indices can increase further markedly over the next decades as they become more representative of the opportunity set of investing in their respective economies. Moreover, we believe that emerging market equities are driven by many factors and the composition of the indices has also influenced the relative valuations between the two segments of the equity universe: Emerging market equities were de-rated during the 1990s as the asset class was hit by numerous solvency and liquidity crises P/E may be an unreliable metric for a single country, especially during crises, due to the relative lack of depth of certain markets Developed market EPS accelerated during the period , however the multiple that investors were prepared to pay for those earnings fell Emerging Market EPS also accelerated markedly during this period, however the P/E multiple increased, with investors even willing to pay a small premium for emerging market exposure in 2007 This increase may be linked to factors surrounding China; after joining the WTO and the partial opening of the domestic equity market, there was a stock market bubble in the period Other emerging market countries, especially those supplying commodities to China (whose GDP was then growing at over 10% per year) were also re-rated during this period Since rallying from the global financial crisis of 2009, emerging markets have de-rated in line with developed markets The convergence between emerging market and developed market P/E ratios is an interesting point to develop. This may be due to several factors: A decrease in economic volatility: sovereign risk declined following the 1990s crises, with much better economic management today. Many emerging market sovereigns have reached investment grade status Economic prospects are linked more to the domestic cycle and less to the global economic cycle (known as decoupling ). This is a gradual process, as countries move up the income scale and the weight of domestic consumption increases Liquidity in emerging markets has increased dramatically. China, including domestic A shares, is one of the most traded markets in Asia; large Brazilian commodity and financial stocks have among the highest market capitalisations in the world 5 Source: UBS Global Equity Research, March There is notably a variation within EM regional and country multiples (with EM Asia literally off the scale in 1998)

9 9 - Emerging market equities does faster growth translate into higher returns? - June 2013 Nonetheless, other risk factors in emerging markets remain material; many are still prone to inflation for structural reasons, due to demographics and deficiencies in infrastructure. The disproportionate weight of foreign flows to market capitalisation or GDP in certain markets, as well as unilateral economic policies may increase currency risks. We therefore believe that the risk premium for investing in emerging market equity compared to developed market equity is partially justified, but also a source of future potential returns. C. Diversification benefit decreasing? Investment in emerging markets has resulted in periods of high returns and equally high volatility. This was notable during the 1990s crises but also during the global financial crisis of 2008, where emerging market returns did not decouple from those of developed markets (even though the causes of the crisis were exogenous). The following chart demonstrates that while emerging markets have been an excellent long-term buy and hold investment, they have not always compensated for their higher risk. In fact, the Sharpe ratio of the investment is fairly volatile and prone to extreme swings. Once again, this additional risk was primarily concentrated in the crisis years pre Since then, the risk-adjusted return of investing in emerging markets has been consistently higher. Exhibit 4: Sharpe ratios of emerging and developed market equities compared (0.50) (1.00) GEM Sharpe ratio USD DM Sharpe ratio USD Dec-94 Nov-95 Oct-96 Sept-97 Aug-98 Jul-99 Jun-00 May-01 Apr-02 Mar-03 Febr-04 Jan-05 Dec-05 Nov-06 Oct-07 Sept-08 Aug-09 Jul-10 Jun-11 May-12 Source: BNP Paribas, MSCI, Factset April 2013 What we do believe is that emerging markets should continue to provide diversification benefits, being driven by a combination of domestic and global factors on aggregate. However, as the following chart shows, the diversification benefit has been much reduced, due to the increase in correlation between the indices notably during the discovery period for emerging markets during the 1990s. There has been a slight reduction in the correlations more recently. This may be due to the greater dispersion of country performance during this time. Exhibit 5: Correlations of emerging and developed market equities and frontier and developed market equities since index inception MSCI World & GEM MSCI World & Frontier Nov-92 Sept-93 Jul-94 May- 95 Mar-96 Jan-97 Nov-97 Sept-98 Jul-99 May-00 Mar-01 Jan-02 Nov-02 Sept-03 Jul-04 May-05 Mar-06 Jan-07 Nov-07 Sept-08 Jul-09 May-10 Mar-11 Jan-12 Sept-12 Source: BNP Paribas, MSCI, Factset April 2013 Overall, our conclusion is that emerging market equities continue to have a higher risk profile than developed market equities which is reflected in the higher risk premium. The diversification benefit of investing in the asset class has diminished significantly. This is because the strategies with lower correlation to market indices (Alpha strategies), target investment in stocks or countries that are outside the main benchmark, such as frontier markets. The correlation of frontier markets with developed markets is still lower than Lastly, as explained further in part II of this document, there remains significant dispersion in the returns of emerging market country and individual stocks, which enhances the diversification potential within the asset class and can be exploited by active country and stock selection. In addition, emerging market equities have exhibited high beta compared to their developed market counterparts, reflecting that extremes of volatility are more likely in emerging markets. We believe this has been compensated, over the long term, by higher returns.

10 10 - Emerging market equities does faster growth translate into higher returns? - June the drivers of Emerging market performance A. What drives EM equity returns? Myths and reality Prospective investors in emerging market equities are often reminded why they should increase their allocations to the asset class. These well-worn and widely-commercialised arguments can be summarised as follows: Higher GDP growth. GDP growth rates in emerging markets in real terms have consistently exceeded that of developed markets, and often by a significant margin, over the last two decades. This enables secular trends such as: infrastructure spending, urbanisation - as labour is attracted to higher wages in industry as opposed to agriculture - and other knock-on effects. Dynamic demographic trends. in emerging markets, despite some notable exceptions (such as China), demographic profiles are skewed towards younger age ranges (majority of population below the age bracket) who have a tendency to have young children and purchase big ticket items such as real estate, motor vehicles and invest in education for their children. Extreme examples of this are Indonesia, India, Turkey, Egypt and Saudi Arabia Structural changes. Due to geopolitical changes and the deep reforms carried out in many emerging markets since the crises of the 1990s, which have been applauded by the capital markets, the cost of capital has fallen. This has likely had a huge effect on both earnings and valuation multiples. Other factors have been: financial sector reforms leading to improvements in investor access and information; the rule of law; and economic stability. However this varies depending on the country and requires careful analysis on a country by country basis. Overall, these factors have not only increased the opportunity set of emerging market stocks but also decreased the cost of capital. Though we truly believe that they influence the longterm performance of the asset class, and are supportive for the future, short-term correlations with these factors may be weak or unproven. To fully explain the factors driving emerging market equity returns and also shed some light on the recent underperformance of the asset class, we need to dig deeper into specific macro factors. 7 Source: BNP Paribas, MSCI, Factset - April Norges Bank Investment Management: Economic growth and equity returns, March 2012 B. Sensitivity of EMs to macro risk factors We therefore decided to test to what extent macro economic factors in general had influenced emerging market equity returns, starting with GDP growth. Though intuitive, we do not see a strong relationship between GDP growth in the shortterm and equity market performance. One explanation for this is the fact that the composition of GDP growth (including the activity of the state, as well as listed and non-listed companies) and the composition of the stock market index are significantly different across emerging markets. Secondly, GDP growth does not feed very efficiently into EPS 8. GDP growth is cyclical in nature, especially so for an emerging market, as it may be influenced by both global and domestic cycles. However, we see a much clearer relationship between the returns of emerging market equities and that of EPS growth and EPS revisions taken as a whole. Here the role of the equity market as a weighing machine has been aptly demonstrated. An investor in emerging market equities should therefore pay particular attention to how efficiently top-line growth feeds into earnings for a particular investment. Indeed, decomposing the returns of both developed and emerging market equity performance over the last two decades, we see that in periods where emerging markets growth is higher, as in , outperformance has also followed. The underperformance of emerging market equities since 2010 may also have been primarily influenced by this factor - as emerging market GDP growth has continued to be robust. Exhibit 6: Decomposition of emerging market and developed market returns in 3 periods EMERGING DEVELOPED EM-DM Period Total Return 9.8% 11.2% -1.4% o/w Dividend 2.4% 2.3% 0.1% Earnings growth 2.0% 3.2% -1.2% Multiple expansion 5.4% 5.5% -0.2% Period Total Return 10.0% 0.3% 9.7% o/w Dividend 3.0% 2.2% 0.8% Earnings growth 9.8% 0.2% 9.6% Multiple expansion -2.6% -2.1% -0.4% Period Total Return 4.0% 9.3% -5.3% o/w Dividend 2.7% 2.9% -0.2% Earnings growth 18.8% 26.7% -7.9% Multiple expansion -14.8% -16.1% 1.3% Source: BNP Paribas Investment Partners April 2013

11 11 - Emerging market equities does faster growth translate into higher returns? - June May 2013 The debate about emerging markets and economic growth does not stop there. We measured the sensitivity of emerging market stocks with various macro-economic factors through correlations. One of the highest correlations we found between emerging market equity performance was that with the OECD Composite Leading indicator, which is made up of components such as industrial production, factory production, raw materials etc. The correlation between the MSCI Emerging Markets index and the OECD Composite Leading Indicator is shown below and amounts to 0.40 in our analysis for the entire period: Exhibit 7: Monthly scatter plot of MSCI emerging market returns with OECD leading indicator from (all returns are month-over-month) EM price change to OECD G7 LI 20.0 EM price change to OECD G7 LI Linear (EM price change to OECD G7 LI) EM price index % change OECD G7 leading Indicator % change Source: BNP Paribas Investment Partners; April 2013

12 12 - Emerging market equities does faster growth translate into higher returns? - June 2013 Which macro-economic factors best explain emerging market equity returns? We decided to measure the sensitivity of emerging market equity performance to other macro-economic factors. One of the largest listed sectors in emerging markets is natural resources so we decided it would be a good place to start. The following data show there is a strong relationship between the asset class and various natural resources prices - especially those which are traded on global markets and where supply and demand are not distorted by regulation or supra-national organisations: Exhibit 8: Correlation coefficient of emerging market returns with commodities COMMODITIES OIL AGRI ENERGY METALS Recovery Expansion SlowDown DownTum Source: Nomura Research Institute, March 2013 Interestingly, the correlation is strongest during periods of downturn, for which the most rational explanation is the tendency for risk assets to re-correlate during times of financial and economic stress. The next area we looked at was the relationship between emerging markets and interest rates. Emerging market equities are strongly correlated with the interest rate cycle represented by the performance of USD emerging bond indices (iboxx USD Liquid EM) and credit quality measured by credit default swaps (Markit CDX), whose prices move inversely to those of credit spreads. Exhibit 9: Correlation coefficient of emerging market returns with interest rate and credit indicators COMMODITIES BOND CDS Markit I Boxx USD Liquid Emerging Markit CDX.NA.HY.19 12/17 Recovery Expansion SlowDown DownTum Source: Nomura Research Institute, March 2013 In addition, we can observe a strong relationship between flows into emerging equity and bonds which is caused by global risk appetite (commonly known as risk on/off ). We have also observed a positive correlation between the performance of emerging market equities and the interest rate spread between short- and medium-term dated US Treasury Bonds (0.34 for the 3m to 10y spread). Emerging market assets are still we believe rightly considered to be part of the risk asset classes. Exhibit 10: Correlation coefficient of emerging market annual returns with US Treasury yields (20.00) (40.00) (60.00) (80.00) US YC (10Y-3M) MSCI EM Dec-91 Febr-93 Apr-94 Jun-95 Aug-96 Oct-97 Dec-98 Febr-00 Apr-01 Jun-02 Aug-03 Oct-04 Dec-05 Febr-07 Apr-08 Jun-09 Aug-10 Oct-11 Dec-12 Source: BNP Paribas Investment Partners; April The last driver we evaluated was the relationship between emerging markets in aggregate and the behaviour of the US dollar. In times of global financial stress, especially where emerging markets have been involved, the flight to quality to US dollar-denominated assets is an observable phenomenon therefore we would expect to see a strong negative correlation between the value of the US dollar and the emerging markets equity index. There has also been increasing financial sophistication with more investors willing to bet against the US dollar to invest in higher-yielding assets, commonly known as the USD carry trade. Hence, the relationship has become even stronger since 2000 (correlation of 0.92 with the inverse of the trade-weighted US dollar index). Exhibit 11: Correlation coefficient of emerging market monthly returns with the inverted trade-weighted US dollar index Jan-90 Real eff x-rate Apr-91 Jul-92 Oct-93 Jan-95 Apr-96 Jul-97 Oct-98 Jan-00 Apr-01 Jul-02 Oct-03 Jan-05 Apr-06 Source: BNP Paribas Investment Partners; April 2013 Jul-07 Oct-08 Jan-10 MSCI EM Apr-11 Jul

13 13 - Emerging market equities does faster growth translate into higher returns? - June 2013 Non-financial drivers in emerging markets We have studied a number of relationships in detail to present what appears to drive emerging market equity performance in the short-term. However, despite weak statistically-significant evidence that it is the case, we believe that long-term GDP growth trends do influence the performance of Emerging Market equities over longer periods. In this case, we look at the predominantly non-financial factors, which should continue to provide positive momentum for the returns of the asset class over the next decades. Demographics the demographic profiles of emerging markets are country-specific, as in developed markets (compare the US with Japan for example). However, many countries in the emerging market universe are skewed towards younger age brackets in their demographic profiles. A good example of this is India, where the majority of the population is less than 35. In theory, a higher proportion of the population in the younger age brackets is positive for consumption and economic growth potential. This is due to the availability of a productive labour force, with a higher propensity to consume. Another way to measure this is in dependency ratios the number of people who depend on a single source of income: where this is falling, there tends to be a positive impact on consumption. Demographic factors are not unequivocally positive for emerging markets however. It is much less of a positive factor in China, for example, for which specific policies to limit population growth from the 1980s have reduced the proportion of the population in the younger age bracket today. This is also the case in Korea, where the rise to high income status has led to a demographic profile such as that of Japan. Therefore, though we believe in general that demographics are supportive for investing in the emerging market consumption theme, this needs to be analysed on a country-specific basis. Structural Reforms The period was characterised by widespread structural reforms in emerging markets, due to the increasing economic power of those countries (increase in GDP) and in many cases, recovery from the crises and economic mismanagement of the previous decade. While they are too numerous to describe in detail here, examples include: - Brazil central bank inflation targeting and independence which has restored confidence in the country s growth and unleashed the significant potential of its industrial and middle-class consumption - Turkey a political transformation which has led to much greater economic stability and a reduction in previous boom-bust cycles, to a path of sustainably high growth and economic improvement. - Russia fiscal reform and inception of a natural resources stability fund which has increased the authority of the state and led to more stable growth prospects based on reliable taxation and greater economic diversification The effect of these structural reforms in many cases has been the taming of hyperinflation, reduction of long-term interest rates and hence the cost of capital, leading to upgrades of sovereign debt. This has been highly supportive of investment in equities in many emerging market countries, with the additional benefit that many of these changes are practically irreversible. Source: United Nations Population Division, Exhibit 12: Population Pyramid for Developed Regions (2015) and Population Pyramid for Emerging Regions (2015) Population Pyramid for Developed Regions (2015) Population Pyramid for Emerging Regions (2015) -6% -4% -2% Male From 95 to 99 years From 90 to 94 years From 85 to 89 years From 80 to 84 years From 75 to 79 years From 70 to 74 years From 65 to 69 years From 60 to 64 years From 55 to 59 years From 50 to 54 years From 45 to 49 years From 40 to 44 years From 35 to 39 years From 30 to 34 years From 25 to 29 years From 20 to 24 years From 15 to 19 years From 10 to 14 years From 5 to 9 years Less than 5 years 0 0 Female Male Female From 95 to 99 years From 90 to 94 years From 85 to 89 years From 80 to 84 years From 75 to 79 years From 70 to 74 years From 65 to 69 years From 60 to 64 years From 55 to 59 years From 50 to 54 years From 45 to 49 years From 40 to 44 years From 35 to 39 years From 30 to 34 years From 25 to 29 years From 20 to 24 years From 15 to 19 years From 10 to 14 years From 5 to 9 years Less than 5 years 2% 4% 6% -6% -4% -2% 0 0 2% 4% 6% Source: United Nations Population Division, 2010.

14 14 - Emerging market equities does faster growth translate into higher returns? - June 2013 Conclusion to Part I Emerging market equities have provided exceptionally strong gains to investors over the last 25 years of observable data, on a currency-hedged basis. However, on an unhedged basis, though returns have been less exceptional they remain superior to those of developed markets. Despite having much higher volatility, the risk-adjusted returns as measured by the Sharpe ratio have also been higher, though this has tended to deteriorate during the last decade. The diversification benefit of investing in emerging markets within a global equity portfolio has also diminished, as correlations with developed markets have risen. In order to truly benefit from an investment in emerging markets today, it seems necessary to seek investment opportunities outside the main benchmark into areas such as small cap stocks, frontier markets and non-core investment styles. Emerging markets are a moving investment target. The opportunity set has evolved from one of discovery (late 1980s to early 1990s), crisis (mid 1990s to 2003) and the rise of China (2003 onwards). Statistical analyses of emerging market data and comparisons with developed markets must take into account the fact that the composition of the emerging markets index has changed dramatically over the last 25 years, the industry composition of the emerging markets index is different (and varies from country to country) and emerging market stockmarkets do not exhibit the same depth and liquidity as their developed market counterparts. The drivers of emerging market equity performance are commercially touted as economic growth, structural change and demographics. The first is the most controversial and difficult to prove over the short-term. This is because the equity markets are not always truly representative of total economic activity within a country and profits do not always accrue efficiently to minority shareholders. There is a mixed pattern to structural change in emerging markets, with a variety of different political and economic systems all providing good results. It is also a myth that emerging markets always benefit from positive demographics a dividend that can rapidly become a liability if is not accompanied by competent government, dynamic job creation and infrastructure investments. We find however that the primary drivers of emerging markets equities on an aggregate basis are commodity prices, the OECD Leading Indicator and the strength/ weakness of the US dollar. Improvement in risk indicators such as credit spreads and liquidity (steepening of yield curves) are also correlated to emerging market equity returns. Emerging market equities have almost always traded at a discount to developed market equities (the above caveats notwithstanding). Paradoxically, in the aftermath of the Global Financial Crisis of 2008 and beyond, even though the economic growth fundamentals of emerging markets have seemed more robust, emerging markets have continued to underperform their developed market counterparts. This is partially due to some fatigue building into the positive scenario brought about by the rise of China. The Asian giant s massive economic awakening to become a key part of the global economy through trade over the last decade has had positive knock-on effects in export markets for commodities and high technology industrial goods. Investors are fearful that the transformation of China s economic growth model will engender a demise of the emerging market asset class, as its main engine slows down we believe this is shortsighted with a number of other dynamic, growth economies with large, young populations taking over from China s leadership. We expect the long-term returns of the emerging market asset class to remain superior to those of developed markets. This should lead to a re-rating of the asset class and continued evolutions of the opportunity set; numerous emerging economies are already ranked in the middle income bracket, while those classified as frontier today are set to become increasingly investable. This should mean that emerging markets as an asset class should continue to evolve before making a timely demise sometime in the next few decades. In the meantime, we expect exceptional returns to continue due to the higher risk premium and low relative valuations.

15 15 - Emerging market equities does faster growth translate into higher returns? - June 2013 Part II How to extract value from the emerging market equity universe Introduction to part II: How to extract value from the emerging market equity universe Investing in emerging market equities has generated exceptional returns to a global equity investor over the long-term, as demonstrated in our previous analysis. Nevertheless the ride has not always been a smooth one, which raises the attractiveness of taking an active approach to allocation. The first point the investor should bear in mind is that the universe is dynamic; any statistical analysis based around the index must take into account the fact that its country composition has been subject to substantial changes and may continue to be so. The effect of this being that relationships observed in the past may not be repeated in the future. Secondly, the universe is weakly heterogeneous. Though global capital flows and risk appetite may have some explicative power on the returns of all emerging market assets, we have noted high levels of dispersion between emerging market country, currency, sector and individual stock returns. Clearly, this increases the potential gains of active management within the asset class - though the almost infinite number of variables and outcomes, render this challenging to say the least. In the following section we anticipate the future expected returns of the asset class and explore a number methodologies for increasing our expected returns and reducing volatility through active management.

16 16 - Emerging market equities does faster growth translate into higher returns? - June modelling emerging market returns a. Emerging market equities expected returns In order to build an expected return estimate for emerging market equities we turned to the Smart Benchmark team, part of the Multi-Asset Solutions (MAS) group at BNP Paribas Investment Partners. The underlying philosophy is that in strategic asset allocation, valuations matter. They may fluctuate over the cycle, but it is reasonable to expect them to mean-revert over a mediumterm (i.e. 5-7 years) horizon. The Smart Benchmark team therefore build an expected return per asset class for the full market cycle (which we consider to be seven years). In short, we follow a dynamic approach favoring cheap assets compared to expensive assets. For equities we look at the cycleadjusted price-earnings ratio (CAPE). The CAPE is the ratio of the inflation-adjusted equity price, to the average of inflation-adjusted earnings over the previous decade. This measure thus controls for short term volatility in earnings caused by the economic cycle. We do not look only at expected returns though, but also at risk in terms of volatility and correlations between asset classes. We use historic data, but as these variables are not stable over time, we weigh recent observations more heavily. For example, this takes into account the increase in the correlation between equities and commodities in the past few years. Currently our estimated CAPE for emerging markets is 14.9, which compares to 17.2 estimated for developed. Exhibit 13: Valuation as a driver of long-run expected returns One year average real returns (%) 40 Emerging market equities (MSCI emerging, USD) 30 Developed market equities (MSCI world, USD) < >30 * Calculated using data from Cycle-adjusted PE ratio Source: BNP Paribas Investment Partners; April 2013 Using this methodology, our current estimate is that annual returns of emerging equities would average 9.9% over the forecasting horizon. This compares favourably with bonds, where we foresee returns ranging from 2% for government bonds, around 3.5% for high-yield bonds and 4.6% for emerging market debt. In fact, our models showed that returns on emerging equities were higher than for any other asset class. For US and European equities we foresee returns of 5.9% and 8.2% respectively. b. Currency hedging for emerging markets As we have seen in the first part of this note, currency risk in emerging markets can be of critical importance for the long-term returns of the asset class. As equity investors, we may not be prepared to take this additional risk. Local currency returns in emerging markets have exceeded those in USD over the very long term. The currency risk has therefore been quite significant: Since 1990, the price return in local currency for the MSCI Emerging Markets index was 20.1% on an annualised basis in local terms and 8.4% in USD terms. Running the analysis from , we see that local currency returns and USD returns for the MSCI Emerging Market index are much closer. From this aspect and given the high cost of hedging emerging market currencies, we believe that currency hedging for an emerging markets equity portfolio is neither beneficial nor efficient for the long-term investor in the asset class. Finally, there are numerous reasons why many emerging market currencies should appreciate over the long-term from now. Firstly, as previously mentioned (see exhibit 11 above), there is a a very strong inverse relationship between emerging market equities and a falling trade-weighted US dollar index. Other factors include stronger economic growth, current account surpluses due to commodity or manufacturing exports and declining structural rates of inflation. Qualitatively, many cite the waning influence of the US dollar bloc and rise of alternative reserve currencies such as SDRs or the Chinese yuan as being beneficial to all emerging market currencies. In addition, due to the preponderance of foreign investor flows in illiquid emerging markets, the performance of equities and currencies may often be correlated.

17 17 - Emerging market equities does faster growth translate into higher returns? - June How to exploit the opportunity set To summarise our findings so far, we believe that expected returns for emerging market equities should continue to be higher than for developed markets and that there is a benefit to allocating more to the asset class than their market cap weight would suggest. a. Diversification benefit within emerging Markets Despite the fact that the diversification benefit of investing in emerging markets relative to developed markets has diminished over the last decade, as explored earlier, the diversification benefit of investing in countries, sectors and stocks within emerging markets remains a source of added value. However, these diversification benefits are also decreasing, with an average five-year pair-wise correlation for the countries in the index rising from 0.33 to 0.60 in a decade to We studied the pair-wise correlation of different countries within the emerging market universe as below: Exhibit 21: Average pair-wise correlations of countries in the MSCI Emerging Markets index in three different periods China 0.32 China 0.41 China 0.66 India 0.32 India 0.41 India 0.66 Indonesia 0.32 Indonesia 0.38 Indonesia 0.66 Korea 0.27 Korea 0.45 Korea 0.66 Malaysia 0.34 Malaysia 0.35 Malaysia 0.66 Pakistan 0.23 Pakistan 0.26 Pakistan 0.21 Philippines 0.35 Philippines 0.23 Philippines 0.59 Sri Lanka 0.24 Sri Lanka 0.09 Sri Lanka 0.42 Taiwan 0.40 Taiwan 0.35 Taiwan 0.66 Thailand 0.35 Thailand 0.39 Thailand 0.66 Argentina 0.33 Argentina 0.43 Argentina 0.50 Brazil 0.43 Brazil 0.48 Brazil 0.70 Chile 0.49 Chile 0.40 Chile 0.61 Colombia 0.24 Colombia 0.36 Colombia 0.63 Mexico 0.43 Mexico 0.45 Mexico 0.68 Peru 0.37 Peru 0.37 Peru 0.57 Venezuela 0.28 Venezuela 0.16 Czech Republic 0.62 Czech Republic 0.30 Czech Republic Egypt 0.58 Egypt 0.23 Egypt 0.28 Israel 0.60 Israel 0.30 Israel 0.28 Hungary 0.68 Hungary 0.40 Hungary 0.40 Morocco 0.35 Morocco Morocco 0.24 Poland 0.66 Poland 0.37 Poland 0.47 Russia 0.67 Russia 0.41 Russia 0.37 South Africa 0.69 South Africa 0.43 South Africa 0.46 Turkey 0.58 Turkey 0.30 Turkey 0.44 Average 0.32 Average 0.36 Average 0.60 Source: BNP Paribas, MSCI, Factset May 2013

18 18 - Emerging market equities does faster growth translate into higher returns? - June 2013 B. Dispersion of returns Another key question here is where are the inefficiencies in emerging markets which enable positive relative returns compared to a standard market benchmark. As the below analysis shows, there are a number of different sources of returns in emerging markets. i) Countries As we have pointed out, the emerging markets universe is a broad collection of countries with a low level of economic and political integration and only a limited number of common factors between them. The risks of investing in emerging markets include a number of idiosyncratic risks, including but not limited to higher cyclical risk, lower liquidity, unstable or ineffective institutions and fluctuating currencies all of which we believe are reflected in the higher expected return of the asset class. It is not surprising that the dispersion of returns between emerging market single countries is high. Though from our data we notice that this has been decreasing, the average standard deviation of the 12 month returns for the last 10 years has been 25.9%. As exhibit 14 below shows, it is also much higher than the dispersion of returns between countries in other global and regional developed market indices. Lastly, while the correlation between the 22 components of the emerging market index has increased, this is a relatively recent phenomenon and may have been exacerbated by exogenous events. The average pair-wise correlation (unweighted) of the countries in the MSCI Emerging Index has increased from 0.38 in the period to 0.65 in the period We believe that this makes a theoretical case for active allocation between countries in the emerging markets universe. Exhibit 14: Cross-sectional standard deviation of emerging market annual country returns 70 ii) Sectors In the first section of the study, we commented on the substantial changes to the sector breakdown of the MSCI Emerging Markets index since its inception. As global integration has increased over the last two decades, so has the integration of certain sectors within the emerging market equity universe: Global pricing for commodities and super-cycle Benign interest rate cycle with the yields on emerging market external debt following those of US Treasuries downwards; a successful fight against inflation in many EM countries, lowering borrowing costs in many cases Increasingly globalised markets for manufactured goods, information technology and services. Apart from the Financial and Natural Resources sectors, other sectors within emerging markets, notably those relating to the consumer, are highly country specific as incomes and consumer habits differ widely across the universe. A great diversity in the regulation of the Utility and Telecommunication sectors is also characteristic of emerging market economies. Therefore, investors need to anticipate both a range of global and local effects when allocating between sectors in the emerging markets index. We see that overall, the potential alpha is lower when allocating between sectors, when compared to countries or stocks, due to the lower dispersion of returns. However, while the correlation between the sectors in the emerging market universe has markedly increased over the last two decades from about 55% to almost 85%, a study published by Bank of America Merrill Lynch in January 2013 suggests that this effect peaked sometime in 2010 at around 95%, with crosssector correlation henceforth on a downward trend EM Countries World Countries 0 Dec-95 Oct-96 Aug-97 Jun-98 Apr-99 Feb-00 Dec-00 Oct-01 Aug-02 Jun-03 Apr-04 Feb-05 Dec-05 Source: BNP Paribas, MSCI, Factset; April 2013 Oct-06 Aug-07 Jun-08 Apr-09 Feb-10 Dec-10 Oct-11 Aug-12 9 Source: Bank of America Merrill Lynch: A stock picker s paradise ; January 2013

19 19 - Emerging market equities does faster growth translate into higher returns? - June 2013 Exhibit 15: Cross-sectional standard deviation of emerging market annual sector returns (%) World sectors GEM sectors Dec-95 Oct-96 Aug-97 Jun-98 Apr-99 Feb-00 Dec-00 Oct-01 Aug-02 Jun-03 Apr-04 Feb-05 Dec-05 Oct-06 Aug-07 Jun-08 Apr-09 Feb-10 Dec-10 Oct-11 Aug-12 Source: BNP Paribas, MSCI, Factset; April 2013 iii) Sectors We believe that the greatest potential gain in the emerging markets universe is to be had from actively allocating between stocks, based on the higher performance dispersion between stocks in the indices. The average annualised standard deviation of 12m stock returns is approximately twice that of country returns, as shown in the exhibit below and is also higher than the corresponding figure for developed market stocks: Exhibit 16: Cross-sectional standard deviation of annual emerging market stock returns (rebased 100) Jan-07 May-07 Sept-07 jan-08 May-08 Sept-08 Jan-09 May-09 Sept-09 Jan-10 May-10 Sept-10 Jan-11 May-11 Sept-11 Jan-12 May-12 Sept-12 Jan-13 Source: BNP Paribas, MSCI, Factset April 2013 GEM Developed In conclusion, we can observe strong dispersion effects between country, sector and stock performance in emerging markets, which makes the universe particularly attractive for active allocators either from a top-down or bottom-up perspective. However, in order to do this more effectively, we believe it is necessary to have a good grasp of the fundamental and often idiosyncratic drivers behind the dispersion effects. Another measure we may look at is the stock-to-stock correlation within the emerging market universe which provides an approximation to which extent the stocks in the universe move together. Given the broad nature of the universe and number of countries represented we would not expect this measure to be particularly high, according to data provided by Merrill Lynch 10 on average has been around 10% (positively correlated, but hardly significant). Though, as we observe this correlation has peaked at around 30% in early 2009 before dropping below its historical average today. While the effect of the global financial crisis has been for stocks to increasingly move together, in reaction to common market stresses and global liquidity, the advantage of taking an active approach to stock picking has increased as returns are less driven by common macro-economic factors and more by specific company fundamentals. 10 * A stock picker s paradise ; BofA Merrill Lynch, 29th January 2013

20 20 - Emerging market equities does faster growth translate into higher returns? - June 2013 C. What are the reasons for this dispersion (qualitative) From a top-down perspective, we believe that there is more value to allocate actively between single countries in emerging markets rather than sectors 11. Intuitively this is because emerging markets are poorly integrated in terms of their economic and political systems, income levels, competitive advantages and rates of economic growth - even for countries that are neighbours and situated in the same region. This is much less the case for developed markets, if we compare the US to Australia and Japan for example, or countries within the European Union, there is less value to be gained from country allocation. There exist opportunities within the emerging markets universe which for macro and micro-economic reasons has behaved differently in the past and this has contributed to the dispersion of returns we have seen above. Case studies China: a converging market Increasingly difficult to classify as an emerging market due to its rapid development and dominant position in the universe, our conviction remains that China should be classified as such for the time being. Visitors to China, depending on whether they visit the modern cities of the eastern seaboard or the chronically underdeveloped western provinces, may indeed supply a different answer to this question. China, a low to middle-income country which happens to be the world s second-largest economy is anything but simple to analyse in those terms. Is it any wonder therefore, that China s asset markets sometimes behave differently? China s special characteristics manifest themselves in: - A rate of real GDP growth superior to any other major market, at over 10% year-on-year for much of the decade Despite having the highest forecast rate of real GDP growth for 2013 amongst developing countries (average: 5.3%), the slowdown since 2009 has been severe, with latest quarterly release at 7.7% year-on-year. - The greatest economic transformation in human history, including the creation of a massive urban consumer class - A uniquely-centralised political and economic system where the reading of government policy is as important as the observation of pure economic factors in order to anticipate currency, market, sector and stock returns - A split onshore / offshore equity market structure which is poorly representative of total economic activity - Variable levels of corporate governance between private and state-owned companies 11 We may also make the case that research of emerging market stocks should be done on a cross-sector rather than country basis, though that is a different debate Not only do these factors influence the returns of China s equity markets but there are ripple effects on the equities of countries that have a close trading relationship to China, including those with a trade surplus, such as Brazil: - Their currencies have appreciated in line with the yuan, which has supported foreign flows - Increase in equity market correlations of China equities with these countries as the earnings of larger listed stocks are increasingly sourced from exports to China - From we observe a correlation coefficient of 0.80 between the MSCI China index and the MSCI Brazil index, the highest pair-wise country correlation within the universe apart from with South Africa (0.82) - One additional reason that this correlation is so high may be that Brazil, with India (0.79) and Russia (0.70) is a component of the BRIC investment theme Exhibit 17: China vs. Brazil equity market returns compared Jun-99 Apr-00 Feb-01 Dec-01 Oct-02 Aug-03 Jun-04 Apr-05 Feb-06 Dec-06 Oct-07 Aug-08 Jun-09 Apr-10 Feb-11 Dec-11 Oct Source: Bloomberg, National Bureau of Statistics - April 2013 Brazil China World NB: The reasons why superior Chinese GDP growth should benefit an investment in Brazilian equities rather than Chinese equities have been discussed in part I of the study. Source: BNP Paribas, MSCI, Factset; April 2013

21 21 - Emerging market equities does faster growth translate into higher returns? - June 2013 Turkey: transformation from boom-bust to regional high-flyer In USD terms (taking the full impact of currency fluctuations), Turkey is a high beta market compared to the index, if you look at the full 20-year history for which data are readily available, this characteristic has fallen from the extreme levels of the 1990s, though it is still not a market for the faint-hearted. The earlier period was characterised by profligate government spending, ultra high inflation, vulnerability to foreign flows and structural deficits. Turkey has achieved fiscal and monetary stability after a series of crises brought about by mismanagement, notably culminating in an IMF bail-out in The paradigm shift brought about by the accession to power of the AK party shows the potential for political changes to act as a catalyst for the economic fortunes of a single emerging market (a good counter-example would be Argentina). This is a notable difference to developed markets where the role of the state is generally less influential in economic matters and hence the performance of listed companies. Exhibit 18: Annual USD returns of Turkey and global emerging markets compared MSCI EM Turkey This was reflected in equity market performance, with two large resource stocks CVRD, a mining company and Petrobras a diversified energy company, accounting for up to 40% of total market capitalisation. Brazil could do no wrong and Brazilians borrowed like the party would never stop until China s economy showed signs of deceleration in 2010 and The Brazilian central bank was forced to slam on the brakes and GDP growth has since downshifted to approximately 2%. Mexico on the other hand fared less well during the previous decade. China (and Brazil s) gain was Mexico s loss as low-cost manufacturing for the US consumer market increasingly moved across the Pacific. Anticipations of recovery in the US economy, the increased competitiveness of Mexican manufacturing due to wage increases and currency appreciation in China and finally that most Emerging Market of idiosyncracies - political change - has seen an about-turn of relative fortunes over the last year or so. Brazil and Mexico s stock markets, like their GDP growth forecasts, have moved in opposite directions since. Exhibit 19: Brazil and Mexico GDP compared (USD billions) Brazil (50.00) Mexico (100.00) Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: BNP Paribas, MSCI, Factset; April Source: BNP Paribas, IMF, World Economic Outlook Database; April Mexico versus Brazil: Rematch For many years over the last decade, Brazil consistently trumped its Latin rival economically, politically and dare we say it in sporting terms. However recently, this has all changed. Both countries had their fair share of economic woes during the 1990s, due to hyperinflation and excessive debt. Brazil however visibly got its act together during the turn of the century. The subsequent reforms of the Cardoso government, including strict targeting of inflation by the central bank, created a more benign environment for the new president Lula s economic miracle. Aided and abetted by China s runaway rates of growth, exports of iron ore and other materials enabled Brazil to post GDP growth rates of up to 6%. Exhibit 20: Brazil and Mexico equity market performance compared (rebased 100) Brazil Mexico World EM Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Source: BNP Paribas, MSCI, Factset; April 2013

22 22 - Emerging market equities does faster growth translate into higher returns? - June quantitative approaches to active country allocation A. Multi-factor country allocation model Emerging market countries equity returns are affected by both domestic and global factors; the latter do not impact single emerging market countries on an equal basis; therefore we believe that a differentiated approach to investing in emerging market countries can add value. For relative return investors, this would take the form of applying overweight and underweight positions to the countries in the benchmark compared to the portfolio. Due to the complexity of analysing simultaneously the economic factors for 22 economies, we believe a quantitative approach is most appropriate. BNP Paribas Investment Partners Financial Engineering department has developed a multi-factor model which results in such a weighting recommendation for each country compared to the index. The factors taken into consideration and backtested thoroughly are shown in the table below. Factors may be used pro-cyclically or on a contrarian basis for example, too much analyst interest in a particular country may provide a negative signal over the time horizon of the model. The information ratio associated with these factors for a particular country are then ranked to form an aggregate weighting recommendation (under constraints) for a global emerging market equity portfolio. Critical analysis of model results and pros/cons The country allocation model has a number of outputs a global portfolio allocation and specific models defined by regions or acronyms (BRIC for example or other combinations for client portfolios). The global model is built from the regional models up; the global universe is divided into four economically or geographically consistent areas: BRIC, EM Europe, Latin America, Africa and the Middle East with the backtest of the factors carried out within each sub-region - so that only the most relevant factors are used. The output of the model is a framework for over-and underweighting countries with a risk budget constraint. The active weights are typically in the range of +/- 5% of their benchmark weight. Clearly, this is an important element of complexity the model has to deal with: the effect of a +/- 5% overweight on China is very different to the same applied to the weight of Morocco, the smallest country in the benchmark. Secondly, the global model is built from using the regional models as a base, which means that there should be consistency in the overall output: a country which is overweight in a regional model should in turn be overweight in the global model. Exhibit 22: List of factors used by BNP Paribas Investment Partners Financial Engineering Team in the global emerging markets equity country allocation model TECHNICAL VALUATION & REVISIONS MACRO MACRO ONE FACTOR

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