THE DIVERSIFICATION BENEFITS AND GROWTH POTENTIAL OF EMERGING MARKETS EQUITIES

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1 THE EMERGING MARKETS SMALL-CAP OPPORTUNITY SEPTEMBER 2014 THE DIVERSIFICATION BENEFITS AND GROWTH POTENTIAL OF EMERGING MARKETS EQUITIES are now well accepted concepts. As the asset class has become more mainstream, many investors are looking beyond broad emerging markets allocations to more specialized mandates. One area of increasing interest is emerging markets small-capitalization equities. Do smaller companies offer even more potential than the broad emerging markets asset class? An analysis of the emerging small-cap stock landscape underscores its distinctive characteristics, even as economic and demographic growth trends in the emerging markets support the increasing attractiveness of this asset class. ECONOMIC GROWTH BACKDROP One key attribute of emerging economies is growth. Although GDP growth for developing economies dropped from 8.7% in 2007 to 4.7% in 2013, this mirrored a slowdown in global growth following the financial crisis beginning in For advanced economies, GDP growth dropped from 2.7% to 1.3% over this same period. Looking forward, the IMF forecasts GDP growth of 5.3% in 2015 for developing economies compared to 2.3% for advanced economies. As emerging markets resume their upward growth trend, for most investors, emerging markets represent a focus on large multinational stocks. These investments, however, are often leveraged to global growth and do not provide full exposure to the greater domestic growth expected for these countries. Small stocks, in contrast, tap directly into emerging markets growth. Exhibit 1 below shows that the large-cap emerging markets sector, represented by the MSCI Emerging Markets index, is largely focused on financials, IT, and energy. In contrast, companies in the MSCI EM Small-Cap index offer more exposure to domestic and consumer-driven sectors and industries such as consumer discretionary and healthcare. See endnotes 1 and 2 1

2 EXHIBIT 1 Sector Weights for MSCI Emerging Markets and MSCI Emerging Markets Small Cap June 2014 Weight (%) MSCI Emerging Markets MSCI EM Small Cap Health Care Industrials Consumer Discretionary Materials Utilities Consumer Staples Information Technology Financials Energy Telecommunication Services Reference to the index is for comparative and illustrative purposes only. It is not possible to invest directly in any index. Source: MSCI. Index Source: MSCI Copyright MSCI All Rights Reserved. Unpublished. PROPRIETARY TO MSCI. CHARACTERISTICS OF EMERGING SMALL-CAP COMPANIES A comparison of the top 10 companies in the MSCI Emerging Markets and Emerging Markets Small Cap indices further illustrates the contrast between exposure to a number of globally focused companies strongly tied to global economic cycles and companies that are leveraged to drivers of domestic growth within EM. As shown in Exhibit 2, the MSCI EM Small Cap index is less concentrated in a limited number of companies and reflects a more diversified opportunity set. The percentage of index weight for the top 10 constituents is 3% in the EM Small Cap index compared to 16% for the EM index. Note also that the top 10 constituents in EM Small Cap comprise less of their respective index (3.0%) than does the single largest holding in the EM index (Samsung at 3.5%). A Herfindahl index calculated on the constituents further demonstrates the greater concentration stocks in the EM index at 0.54, versus 0.08 for EM small, which one might expect given that stocks can eventually outgrow the small-cap index, thereby imposing a natural limit on the degree of concentration. A Herfindahl or Herfindahl-Hirshman Index (HHI) is a commonly accepted measure of market concentration, calculated by squaring the market share, or weight, of each firm and summing the resulting numbers. Markets with the highest concentration would have a score of one while the score approaches zero when a market is occupied by a large number of firms of relatively equal size. The index increases both as the number of firms in the market decreases and as the disparity in size between those firms increases. 2

3 EXHIBIT 2 Top 10 Companies and Index Characteristics for MSCI Emerging Markets and Emerging Markets Small-Cap Indices June 2014 MSCI EM MSCI EM SMALL CAP INDUSTRY % INDEX WGT INDUSTRY % INDEX WGT Samsung Electronics Co., Ltd. Semiconductors & Semi Eq Mondi Limited Paper & Forest Products 0.35 Taiwan Semiconductor Manufacturing Semiconductors & Semi Eq Semiconductor Manufacturing Intl Semiconductors & Equip Tencent Holdings Ltd. China Mobile Limited Internet Software & Services Wireless Telecom Services 1.90 Brait S.E. Capital Markets Sibanye Gold Ltd. Metals & Mining 0.34 China Construction Bank Banks 1.33 Hyprop Investments Limited Real Estate Invest. Trust 0.30 Gazprom OAO Oil & Gas 1.25 Equatorial Energia S.A. Electric Utilities 0.30 Industrial & Commercial Bank of China Banks 1.14 Alsea, S.A.B. de C.V. Hotels, Restaurants & Leisure 0.29 Naspers Limited Media 1.13 AVI Limited Class Y Food Products 0.28 Itau Unibanco Holding SA Banks 0.98 Mando Corporation Auto Components 0.26 Hon Hai Precision Industry Co. Electronic Equipment 0.91 Tongaat Hulett Limited Food Products 0.25 TOTAL % TOP CHARACTERISTICS MSCI EM MSCI EM SMALL CAP Median Cap (US $ mil) 6, Weighted Avg. Cap (US $ mil) 45,100 1,071 Index Constituents 835 1,818 Herfindahl Index Reference to the index is for comparative and illustrative purposes only. It is not possible to invest directly in any index. For illustrative purposes only. The securities mentioned should not be construed as investment advice or a recommendation to buy or sell a specific security. Source: MSCI. Index Source: MSCI Copyright MSCI All Rights Reserved. Unpublished. PROPRIETARY TO MSCI. See endnote 3 A Herfindahl or Herfindahl-Hirshman Index (HHI) is a commonly accepted measure of market concentration, calculated by squaring the market share, or weight, of each firm and summing the resulting numbers. Markets with the highest concentration would have a score of one while the score approaches zero when a market is occupied by a large number of firms of relatively equal size. The index increases both as the number of firms in the market decreases and as the disparity in size between those firms increases. 3

4 The MSCI Small Cap index has less than 1% of its constituents above US$5 billion in capitalization. In contrast, the MSCI EM index has 86% of its constituents above this size threshold. In addition, with over 1,800 stocks, the MSCI EM Small Cap index offers a significantly broader number of constituents than the roughly 800 stocks in the MSCI EM index, potentially providing more opportunity for active management. RETURNS AND RISKS As Exhibit 3 shows, the MSCI EM Small Cap index has outperformed both the MSCI EM and World equity indices by a considerable margin since In addition, and perhaps surprisingly for many investors, emerging markets small-caps have exhibited only minimally greater volatility and approximately the same beta as large-cap emerging stocks. The EM Small Cap index has been modestly less correlated with MSCI World returns over the period, but has also underperformed in periods of market distress most notably during the Global Financial Crisis, when the MSCI EM Small Cap index lagged both MSCI EM and World indices. EXHIBIT 3 MSCI Index Returns Data January 2001 to June 2014 (USD returns with gross dividends) CURRENT VALUATIONS EM SC EM WORLD Annual Returns 13.5% 11.9% 5.2% Annual Std Dev 24.0% 23.3% 16.1% Return/Risk Beta (to World) Correlation (to World) larger-cap emerging markets stocks, including price/ book and price/sales ratios. In contrast, EM small-caps currently trade at a premium on the basis of price/ earnings in comparison to EM and World indices due to increasing investor interest in the asset class as well as strong growth projections estimated annual earnings growth for EM small-cap companies is expected to exceed 70%, as compared to 20% for EM large cap and World equities. EXHIBIT 4 MSCI Index Valuations June 2014 MARKET EFFICIENCY AND VALUE-ADDED Another key aspect of emerging small-cap stocks is that this asset class represents a less efficient marketplace, offering a richer ground for active stock selection and the potential to find undervalued securities. Of the stocks in the MSCI Emerging Small Cap index, over 20% of its constituents have no analyst coverage, versus less than 1% for EM and World companies. In addition, there are several thousand potentially attractive small-cap stocks not covered by the index. The investable universe of emerging markets small-cap companies is over 5,000 stocks, compared to some 800 for large caps offering a vast pool of potentially unrecognized value and untapped opportunity. EM SC EM WORLD Price/Book Value Price/Cash Earnings Price/Earnings Dividend Yield Price/Sales Consistent with what we tend to see globally for smallcap stocks, emerging markets small-cap stocks trade at a discount on some valuation measures relative to Reference to the index is for comparative and illustrative purposes only. It is not possible to invest directly in any index. Source: MSCI. Index Source: MSCI Copyright MSCI All Rights Reserved. Unpublished. PROPRIETARY TO MSCI. 4

5 EXHIBIT 5 Manager Performance Mean Annual Value-Added (%) MSCI Emerging Markets MSCI EM Small Cap Year 3 Years 5 Years MercerInsight MPA. Returns ending June For Illustrative purposes only. The chart above shows the Emerging Market Small Cap and Emerging Markets index performance vs. Emerging Market Small Cap and Emerging Market managers respectively, included in the Mercer universe over different time periods. Reference to the benchmark is for comparative and illustrative purposes only. The performance information presented here is net of transaction costs, gross of management fees. Investors have the opportunity for losses as well as profits. Past performance is no guarantee of future results. Index: MSCI Emerging Markets Small Cap. MSCI Emerging Markets. Copyright MSCI All Rights Reserved. Unpublished. PROPRIETARY TO MSCI With this as a backdrop, perhaps not surprisingly, the mean value-added by active managers of EM small-cap strategies has materially exceeded that for EM strategies for the past one, three, and five years, as shown in Exhibit 5. CONCLUSION At the asset class level, we believe an allocation to emerging markets small-cap stocks has a number of potential key benefits, including: Greater exposure to local economic growth in developing countries, A broader, more diversified set of companies with strong expected earnings growth, Stronger historical returns, with reasonable risk, at valuations which are currently in-line with larger-cap companies, A demonstrated ability of many managers to add value above their benchmarks. Given the expected continuation of economic and demographic growth in emerging markets, it would appear that the EM small-cap sector may be one of the best ways to gain exposure to the future growth drivers of the world economy. ENDNOTES 1 While the link between GDP growth and equity market returns has been debated, there is some solid recent evidence to support it. See Arnott, Robert D., and Denis B. Chaves, Demographic Changes, Financial Markets and the Economy, Financial Analysts Journal, vol. 68, January/February IMF World Economic Outlook, April Copyright MSCI All Rights Reserved. Without prior written permission of MSCI this information and any other MSCI intellectual property may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used to create financial instruments or products or any indices. This information is provided on an as is basis, and the user of this information assumes the entire risk of any use of this information. Neither MSCI nor any third party involved in or related to the computing or compiling of the data makes any express or implied warranties, representations or guarantees concerning the MSCI index-related data, and in no event shall MSCI or any third party have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) relating to any use of this information. 5

6 LEGAL DISCLAIMER This document was prepared by Acadian Asset Management LLC with information it believes to be reliable and contains Acadian s confidential and proprietary information. The views expressed within are those of Acadian and are subject to change with market conditions. This is provided for informational purposes only and should not be construed as investment advice, or an offer to sell or a solicitation of an offer to buy any security. This document has not been updated since it was published and may not reflect the current views of the author(s) or recent market activity. Market conditions are subject to change. Historical economic and performance information is not indicative of future results. This document may not be reproduced or disseminated in whole or part without the prior written consent of Acadian Asset Management LLC Acadian Asset Management LLC All rights reserved. 6 For institutional investor use only. Not to be reproduced or disseminated