Investing in Emerging Markets It Is Not What It Used To Be

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1 Investing in Emerging Markets It Is Not What It Used To Be Brian J. Gibson, CFA Senior Vice President, Public Equities Alberta Investment Management Corporation Background and History Over the decades, the prospect of investing in emerging markets held the tantalizing prospect of providing both higher returns and lower overall portfolio risk due to the low correlation of emerging markets. While emerging markets did enjoy brief periods of attractive performance, it was very difficult to obtain sustainable results. In addition to the poor liquidity of the emerging markets, there were major setbacks because of economic and fiscal crises in many of the countries. Being an emerging markets investor in those days was a little like being an explorer searching for Shangri La. Economic growth rates in developing countries were fairly episodic and relied mainly on cyclical improvements in the demand for raw materials by the developed countries. Domestic savings rates were small or non-existent in the developing countries, partly because per capita GDP was so low and partly because profits and capital were often moved off shore. Just looking at the twentieth century up to 2008, there were a large number of debt defaults or rescheduling amongst developing countries. Here are a few notable examples 1 : 1 Taken from This Time Is Different by K. Rogoff and C. Reinhart, Princeton University Press, Pp

2 Egypt 1983, 2000 Nigeria1982, 1986, 1992, 2001, 2004 South Africa 1985, 1989, 1993 India 1958, 1969, 1972 Indonesia 1966, 1998, 2000, 2002 Poland 1936, 1940, 1981 Russia 1918, 1991, 1998 Turkey 1915, 1931, 1940, 1978, 1982 Argentina 1951, 1956, 1982, 1989, 2001 Brazil 1902, 1914, 1931, 1937, 1961, 1964, 1983 Chile 1931, 1961, 1963, 1966, 1972, 1974, 1983 Mexico 1914, 1918, 1982 Venezuela 1983, 1990, 1995, 2004 The public equity markets in developing countries also were fairly illiquid, a fact that was often exacerbated by capital controls. The stock markets in developing countries were relatively small when compared to markets in developed countries. Emerging markets sometimes offered the illusion of investment Shangri La. The reality was that the markets resembled an illiquid, small public company with a very high debt load. The realized returns over time were not outstanding except for relatively brief periods MSCI Index Performance: Emerging Markets vs. Developed Markets* MSCI EM Price Index (Left Scale) MSCI DM Price Index (Right Scale) /1/1988 1/1/1989 1/1/1990 1/1/1991 1/1/1992 1/1/1993 1/1/1994 1/1/1995 1/1/1996 1/1/1997 1/1/1998 1/1/1999 1/1/2000 1/1/2001 1/1/2002 1/1/2003 1/1/2004 1/1/2005 1/1/2006 1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011 Source: Bloomberg * rebased 12/31/1998=100 2

3 Until recent years, news was slow to travel. Even when news was received, it was usually difficult to make an investment response. It may seem hard to believe today but until fairly recently, it was extremely difficult to actually transfer money into or out of developing countries. As economists would say, There was a lot of friction. This friction often gave the appearance that emerging markets were less correlated to developed markets than was actually the case. The results were even less satisfactory on a risk-adjusted basis, after adjusting for the higher beta of emerging markets and their lesser liquidity. What, if anything, is different now? As it turns out, there is a lot that is different. The markets are not what they used to be. With hindsight, the Asian financial crisis of the mid-1990s and the Russian debt default of 1998 were probably the best things to happen to emerging markets. In response to the crises, bodies such as the International Monetary Fund forced the developing countries to take some very harsh medicine. Government fiscal positions were dramatically improved, often achieved with some very draconian budget cuts. Relatively tight monetary policies were ruthlessly implemented. Trade balances and capital flows adjusted in response. Public sector borrowing moved from relying on short-term foreign currency loans to relying more on longer-term domestic loans. Investments were driven more by direct foreign investment than by short-term foreign currency loans and shortterm portfolio flows. Domestic capital markets were reformed in many countries. The economic reforms of the 1990s also happened at a time of tremendous technological progress and financial innovation. By the 1990s the world began to see the emergence of a global network of fairly low cost telecommunications. The dramatically lower cost of telecommunications enabled tremendous information flows around the world. This meant that news began to travel instantly far and wide. Detailed information on public companies in developing countries is now readily available on the Internet. The telecommunication infrastructure also enabled financial innovations. Banks became much more global and they all built, or joined, low cost global funds transfer networks. The new ability to instantly transfer large sums of money to almost any country in the world at the click of a computer mouse was the most important innovation to affect investment flows. On a personal basis, we can all now travel to almost any country in the world and get cash from the local ATM. This is quite a change from the old days. Finally, the real cost of airline travel has declined dramatically at the same time as airlines have developed more comprehensive route networks. A lot of the friction has simply melted away. The combined result of these changes during the 1990s was the emergence of more liquid, more transparent, and more efficient public equity markets in developing countries 3

4 Market Cap: MSCI Emerging Market as % of MSCI AC World 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% So, have we reached Shangri La? Well, not quite. Many developing countries still have high debt loads and some do not generate sufficient investment capital on their own. Many developing countries still have fairly undiversified or unbalanced trade flows. The improved efficiency and liquidity of investing in developing markets came with a Faustian bargain emerging markets are now more correlated with developed markets, reducing some of the diversification benefits. 4

5 Changing Correlation of MSCI 2 Emerging Markets To MSCI Developed Markets 5 years ended Beta (3 years) 1.11 Constructing an Emerging Markets Portfolio Most investors use the MSCI Emerging Markets Index as their point of reference for an emerging markets equity portfolio. There are various ways to approach the task of constructing a portfolio of emerging market stocks. The approach chosen will depend on the investor s objectives. In some cases, an investor simply wants to gain exposure to emerging markets. For those investors, a simple index replication strategy or a synthetic index would be appropriate. The challenge in past years was that it was horrendously expensive to acquire index exposure to emerging markets. Limited liquidity and relatively high settlement and delivery costs made it very expensive to build a portfolio that would replicate the MSCI index. Liquidity has improved and settlement costs have declined in recent years, making this approach much more feasible. An alternate approach would be to acquire synthetic index exposure using index swaps. In the past, the swap counterparties would demand very high swap spreads because of their high cost of acquiring the underlying equities. It was rare to get a total return swap on the MSCI Emerging Markets Index for less than LIBOR %. Today, most global counter parties have large inventories of emerging markets equities. This fact, together with the larger size of emerging markets and greater investor interest in the sector, has caused swap spreads to be more attractively priced. Current swap spreads are a fairly reasonable LIBOR %. Intelligent investment of the swap collateral can offset most, or all, of the 0.35% cost. In other cases, an investor wants to generate risk-adjusted returns that are above the returns of the MSCI Emerging Markets Index. Active security selection is much easier these days because of the above mentioned improvements in access to information and the regulatory reforms that have occurred. The biggest challenge with both passively and actively managed portfolios is risk management. The relative volatility of emerging markets is fairly high. The MSCI Emerging Markets Index has an estimated beta, or relative price volatility, of 1.1 times when compared to the broader MSCI World Index. This higher volatility is partly due to the limited 2 MSCI is a trademark of MSCI Inc. 5

6 diversification of the emerging markets index and partly due to the higher impact that investment capital flows have on the smaller emerging markets. The limited diversification of the emerging markets still presents the biggest challenge to achieving risk diversification when employing active security selection. The reality is that the markets of some countries are fairly small and there is limited liquidity within many markets. There also is a lack of diversification by country, by sector and by company. The MSCI Emerging Markets Index includes twenty-one countries. The top five countries represent two-thirds of the index, by weight. The top seven countries make up 80% of the index. The remaining fourteen countries are fairly small, making it difficult to achieve good country diversification. 6

7 COUNTRY Weights % Cumulative % China Brazil South Korea Taiwan India South Africa Russia Mexico Malaysia Indonesia Turkey Chile Thailand Poland Colombia Peru Philippines Egypt Hungary Czech Morocco The emerging markets index also has a fairly uneven distribution of industries. As shown in the table below, materials, energy and financials account for a disproportionate 54% of the index. The remaining industries have fairly small individual weights. 7

8 SECTOR Weights % Cumulative % Financials Materials Energy Information Technology Tele Services Industrials Staples Cons Discr Utilities Health Even when an investor is not concerned about country or industry exposure, there are not a lot of larger, liquid public companies in emerging markets. The MSCI Emerging Markets Index includes 755 different companies. However, the fifty largest companies account for 40% of the index. The top 100 companies, by size, account for 53% of the index. There are a limited number of more liquid companies in any one country. The top twenty companies easily dominate each country market. Here is the level of concentration for the largest twenty companies in each of the seven larger countries in the index: Country Share of Local Market Brazil 75% China 63% India 71% South Africa 77% South Korea 61% Russia 95% Taiwan 61% By the time an investor has reached the twentieth company in these countries, the remaining companies have individual weights of less than 1%. Most investment managers do not manage pools of capital that enable them to take a long-term approach to investing in emerging markets. Those managers have to be concerned about liquidity. This means that they tend to focus on the subset of more liquid shares. As a result, the more liquid companies are more efficiently priced and provide less opportunity for stock pickers to add value to a portfolio. Talented investment managers can add value to an actively managed, emerging markets equity portfolio. It is just that the liquidity structure of the markets make it very difficult for any manager to deliver consistent, risk adjusted returns that are superior to the market, or to outperform his or her talented peers. For those investors who manage pools of patient, long-term capital, it can be very lucrative to invest in emerging markets. These investors are free to acquire fairly large 8

9 stakes in the less liquid, less efficiently priced smaller companies within the emerging markets. There are many excellent, smaller companies in the emerging countries. Local knowledge and detailed research often can ferret out these companies. The key to taking advantage of these opportunities is that the investor has to be sure that he or she has a three to five year time horizon, and will not be forced to sell because clients suddenly need liquidity. The investor also has to be prepared to work continuously for years to develop and maintain the necessary local knowledge. Portfolio Construction at Alberta Investment Management The investment mandate at Alberta Investment Management ( AIMCo ) is to earn consistent, risk adjusted returns that are above the returns that can be earned from passive market exposure. Given our mandate, we have to actively manage our investments in emerging markets. The challenge in doing this was to find an approach that takes into account the various risks and constraints that were outlined above. As noted, it can be very difficult to construct a well-diversified portfolio of emerging market companies. Rather than trying to manage emerging markets risks on a standalone basis, we look at the risks in the context of our entire public equity program. AIMCo manages about $23 billion in its public equity program. We obtain exposure to emerging markets equities in three ways: through the emerging markets portion of portfolios benchmarked to the MSCI All Country Weighted Index; a separate $1 billion Emerging Markets Pooled Fund; and through certain direct investments in emerging markets companies. The total program is designed with three components: passive exposure; two, concentrated, high conviction portfolios; and a handful of large direct investments in especially attractive companies. The passive index exposure is used mainly for risk management and is used at times when there is an insufficient amount of attractively priced, specific investments. Each concentrated portfolio is externally managed and is designed to earn the majority of its return from bottom up security selection by two very experienced managers. Neither portfolio looks much like the index. Both portfolios are constructed almost entirely on the basis of individual security selection. Many of the investments are in the less liquid companies that are often overlooked by other investors. The expected return for each portfolio is more than enough to pay us for the active risk that is used. In reality, some of the stand-alone risk of each of these two portfolios is reduced because we have two portfolios that generate non-correlated value added. We further reduce and manage risk, and provide a liquidity cushion, by operating a small portfolio of emerging markets index swaps. In addition to these activities, we make direct investments in companies in two countries where Alberta Investment Management has a lot of investment experience Brazil and Colombia. We are able to pursue high return, direct investments because we have a team that manages a large portfolio of direct investments in companies around the world. 9

10 Finally, we manage any remaining unwanted risk exposures as part of our department wide risk management process. For example, the sector tilts in our emerging market program may be offset by different sector tilts in the rest of our program, or the overall sector tilts may be hedged by our departmental risk management managers. The result for our clients is an investment exposure to emerging market equities that has a high amount of expected value added, but with only marginal impact on their total equity risk. The emerging markets are certainly not what they used to be, but they still represent a fertile area for generating attractive amounts of value added. 10

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