Emerging markets: The multi-asset approach

Asset management research June 212 Emerging markets: The multi-asset approach 1

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Executive Summary Emerging markets offer attractive long-term investment prospects Their advantages over developed markets include more favorable demographics; more rapid growth in productivity and economic output; and governments, companies and households that are less indebted International investors exposure to equities and bonds in emerging markets is underweight but expected to increase gradually in the long term The particular risks of investments in emerging markets include short-term outflows during periods of market stress, higher historical rates of sovereign debt defaults and restructurings, and higher perceptions of corruption, legal and political risk relative to developed markets Investors can mitigate these risks and improve outcomes from investments in emerging markets by broad diversification, including exposure to currencies and commodities Active asset allocation in emerging markets is preferable to fixed allocations to each asset class Returns can be further enhanced by allocating investments in each asset class to specialist managers who seek to add value through bottom-up security selection UBS Global Asset Management s advantages in multi-asset emerging markets investments include a 3-year track record; local presence in key locations in emerging markets; coverage of a broad range of asset classes, with regular interaction between teams in different regions and asset classes; and specialist teams dedicated to risk management and manager selection 3

Introduction Many investors are inspired by emerging markets. Investing in countries with low or middle incomes and high growth rates enables investors to participate in the rapid development that is transforming the global economy and improving the living standards of many millions of people. Investments in emerging markets have historically generated impressive returns but also high levels of volatility. As emerging markets account for a growing share of global GDP and market capitalization, they are evolving from a satellite to a core investment. For most investors, it makes sense to invest in more than one asset class. Multi-asset investing offers a wider range of opportunities and diversification benefits, since different asset classes tend to perform well at different times. So, in the long run, multi-asset investing can offer better risk-adjusted returns. A strategy that combines the opportunities of emerging markets with the benefits of multi-asset investing therefore offers many advantages. Given the risks of emerging markets and the complexities of multi-asset investing, however, such a strategy needs many elements to succeed. In this paper, we present the case for investing in emerging markets using a multi-asset approach. We describe what we believe are the key requirements for a successful multi-asset emerging markets strategy. Finally, we outline the capabilities in this area offered by UBS Global Asset Management. Why invest in emerging markets? Emerging markets can be defined as countries that have reasonably large, investable financial markets but are still at a relatively early stage of economic development, with GDP per capita far below the levels of advanced economies such as the US, Japan and Germany. These markets are attractive for many reasons. Here, we highlight five. First, demographic trends are generally more supportive in emerging markets. The faster a country s workforce is growing, the faster its economy can grow. Figure 1 shows how the largest emerging economies (except Russia) should see substantial growth in their workforces during the current decade, while most developed markets (except the US) will probably see their workforces shrink. Figure 1: More workers Forecast growth in labor force, 21 to 22 (m) 15 12 9 6 3-3 2 15 1 5 India China China India Indonesia Brazil US Brazil Russia Indonesia US Japan Russia Japan Germany Europe Source: World Bank, Euromonitor, US Census Bureau, CLSA Asia Pacific Markets, as of April 211. Note: The prediction, projection and forecast of economies or markets are not necessarily indicative of the future or likely performance of the UBS Emerging Markets Allocation Fund. Second, impressive labor productivity growth means that emerging economies are generating more output per worker. While the value of output per worker is still lower in emerging markets than in advanced economies, the gap is narrowing. Figure 2 shows how productivity grew much faster in the leading emerging economies than in the biggest advanced economies over the past decade, with the exception of Brazil. Although productivity growth is harder to forecast than demographic changes such as growth in the workforce, we expect this trend to continue. Figure 2: Workers becoming more productive Change in labor productivity, 21 to 211 Source: Conference Board, UBS Investment Bank. Based on labor productivity per person employed, in 211 USD, converted to 211 price level with updated 25 EKS PPPs. UK 4

Third, emerging markets are the best place to look for economic growth. This follows from the first and second points above. Economic output, defined as GDP, is simply output per worker (i.e. labor productivity) multiplied by the number of workers. Figure 3 shows how, for the past several years, emerging economies have consistently accounted for the majority of global GDP growth a trend that is expected to continue. Their share of global GDP has risen substantially over the past decade, as Figure 4 shows. Figure 3: Emerging economies lead the way Contributions to global GDP growth 12 1 8 6 4 2-2 -4 198 1985 Emerging Markets Source: IMF, Morgan Stanley 4 35 199 1995 Developed Markets Figure 4: A growing share Emerging markets share of global GDP 2 25 211E Fourth, emerging economies have sound balance sheets that provide a solid base for the continued economic outperformance that we expect them to deliver. Emerging economies are less indebted than advanced economies. Figure 5 shows how government debt levels are low and falling in emerging economies but high and rising in advanced economies. The ongoing sovereign debt crisis in the eurozone shows the problems that can result from high government debt levels. It is no surprise that sovereign debt ratings are rising in emerging markets but falling in developed markets, as shown in Figure 6. Figure 5: As one gap widens... Sovereign debt to GDP ratio 15 12 9 6 3 AA23 AAA 2 Emerging Markets 24 28 Developed Markets 212 G7 countries 216 Source: IMF, Morgan Stanley. Averages are weighted by GDP at purchasing power parity (PPP). Based on IMF forecasts. Figure 6:... another gap narrows Weighted average of long-term foreign currency sovereign debt ratings 3 25 2 2 18 A 16 BBB 14 15 198 1984 1988 1992 Source: IMF, UBS Investment Bank 1996 2 24 28 212 12 BB 1 25 26 27 28 29 21 211 Emerging Markets Developed Markets Source: Deutsche Bank based on the average of S&P, Moody s and Fitch ratings 5

Private sector balance sheets also tend to look more solid in emerging markets. Figure 7 shows how private sector credit, i.e. debts owed by companies and households, is generally much lower in emerging markets. The two exceptions are China, which has much higher private sector credit levels than other large emerging economies, and the US, which has much lower private sector credit levels than other large, developed economies. Figure 7: Less indebted companies and households Private sector credit as a percentage of GDP 2 15 1 5 China India Brazil Russia Indonesia Source: IMF Banking Survey. Data as of year-end, 211. Eurozone Japan Fifth, emerging markets are still structural underweights for many investors. In other words, investors do not have as much exposure to these markets as their size would suggest. Figure 8, for example, shows mutual funds structural underweights in emerging market equities and bonds, i.e. the gap between their holdings of those asset classes and the amount they would own if their holdings reflected emerging markets share of global market capitalization. But this gap is closing gradually emerging markets have received equity inflows of USD15bn and bond investment inflows of USD5bn since the start of 26. Investors gradually increasing their emerging markets exposure to reduce their structural underweight would be positive for emerging markets. Figure 8: Two under Mutual funds structural underweights in emerging markets -3-6 -9 US UK Handle with care While emerging markets are attractive to investors, they also require particular care and attention. The inflows described above are not a one-way flow emerging markets saw outflows of USD5bn in 28, and USD35bn in 211. They are often less liquid than developed markets, which magnifies the impact of flows on prices, making them rise even more when investors are clamoring to get in but fall even faster when they are trying to exit. This is one reason why emerging markets are typically more volatile than developed markets. Although Figure 6 shows that the sovereign debt ratings gap between emerging and developed markets is narrowing, it also shows that emerging markets still have lower debt ratings today, on average. This time is different, a historical study of financial crises by Carmen Reinhart and Kenneth Rogoff, lists 71 sovereign debt defaults and restructurings in emerging markets between 1975 and 26, with none in developed markets. Examples of defaults by large emerging economies include Russia in 1998, Argentina in 21 and Indonesia in 22. Emerging markets have also been more vulnerable to currency crises. Emerging markets are also associated with greater legal, political and governance risks. Foreign investments in emerging economies have in many cases been expropriated by national governments. Legal contracts tend to be harder to enforce. Emerging economies are seen as suffering from higher levels of corruption, as Figure 9 shows. Figure 9: Standards vary widely Corruption Perceptions Index score, 211 (1 is least corrupt, is most corrupt) 8 7 6 5 4 3 2 1 China India Source: Transparency International Brazil Russia Indonesia US Germany Japan UK -12-15 Equities Bonds Source: EPFR, IMF, UBS Investment Bank. Data as of end-21. Underweight is defined as the difference between emerging markets share of mutual fund investments in an asset class and emerging markets share of that asset class s global market capitalization. 6

How to invest in emerging markets How should investors handle the multiple challenges of emerging markets, including sovereign and currency risks, legal and governance risks, market volatility and vulnerability to outflows? We think the three key factors are broader diversification, excellent risk management and active asset allocation. 1. Broad diversification In volatile markets, diversification is particularly important since different asset classes tend to perform well at different times, so a diversified strategy should offer less volatility and better risk-adjusted returns in the long run. In developed markets, the classic example is bonds and equities, which historically have shown a very low correlation, meaning they offer great diversification benefits. Figure 1 shows how bond-equity correlations are higher, and therefore diversification benefits smaller (but still significant) in emerging markets. Figure 1: Less diversification benefit Rolling 2-year correlation of total returns Average two-year correlation of total returns in developed markets (DM) and emerging markets (EM).4.35 3. Active asset allocation Active asset allocation brings diversification and risk management together. Keeping fixed allocations to asset classes or regions, such as maintaining a 5% allocation to equities and 5% to bonds or keeping an emerging markets strategy s exposure to Asia fixed at 6%, is a rigid approach. It restricts investors ability to increase exposure to undervalued assets, or to pull out early from a region or asset class where there are deteriorating investment fundamentals or where a bubble could be about to burst. With active asset allocation, by contrast, an asset manager varies exposure to regions and asset classes based on current economic and market conditions. If they are executed successfully, broad diversification, excellent risk management and active asset allocation can reduce the size of an emerging market strategy s drawdowns, i.e. peak-to-trough losses. We have described an investment approach mainly at the asset allocation level. However, investors should not ignore the possible benefits of security selection in emerging markets. The potential to generate extra gains by investing in outperforming equities or debt issuers, and avoiding the worst-performing ones, is at least as important in emerging markets as it is in developed markets..3.25.2.15.1.5. DM EquitiesDM bonds EM EquitiesEM bonds (LC) EM EquitiesEM bonds (HC) Source: Bloomberg, UBS Investment Bank. LC and HC refer to local currency and home currency, respectively. Average two-year rolling correlation from December 23 to March 212, based on USD total returns for the following indices: MSCI World Index (DM equities), MSCI Emerging Market Index (EM equities), Bloomberg/ EFFAS 7-1Y, USD (DM bonds), JP Morgan Global Bond Index - Emerging Markets, USD (EM bonds, LC), EM Debt (HC) JP Morgan - Emerging Markets Bond Index, USD (EM bonds, HC). So in emerging markets, the diversification offered by a bonds-plus-equities strategy is good but not good enough. Broad diversification means investing in more than just equities and bonds. Investors can gain further diversification benefits by adding exposure to other asset classes such as currencies and commodities. This is particularly important in emerging markets, where correlations between bonds and equities are higher than elsewhere. 2. Risk management Risk management involves a wide range of considerations, including avoiding excessive exposure to a single investment or region. It should ensure that investments have the necessary liquidity levels even in times of market stress. It should also attempt to anticipate periods of unusually high volatility by adopting a more conservative allocation before the volatility reaches its highest levels. 7

Why choose us? For investors seeking a multi-asset investment strategy in emerging markets, we would highlight the following advantages of UBS Global Asset Management. 1. Experience. Our 3-year track record in multi-asset investing in both developed and emerging markets, based on active asset allocation, is one of the longest in the industry. 2. Global coverage. Our Global Investment Solutions team offers a network of multi-asset investment professionals based in seven time zones, with specialists in areas including asset allocation, currency, manager selection and risk management. 3. Breadth of asset classes. Our multi-asset investment strategy includes exposure to equities, fixed income, currency and commodities. 4. Manager selection expertise. Our manager selection team aims to improve returns at the security selection level in our multi-asset emerging markets strategy, by seeking the best specialist bottom-up investors, both within UBS Global Asset Management and among third-party investment firms. 5. Cross-asset perspectives. Our quarterly Cyclical Market Forum brings together representatives from all of UBS Global Asset Management s investment teams including Global Investment Solutions, emerging markets equities and emerging markets debt in order to generate investment insights that can be used across several asset classes and strategies. 6. Strong risk management. Our Global Risk System is a state-of-the-art set of tools that enables investors to analyze risks at all levels from asset allocation to single transactions, with features including stress testing and liquidity risk assessment that are particularly relevant to emerging markets. Authors Andreas Koester, CFA Head of Asset Allocation and Currency Global Investment Solutions Matthew Richards, CFA Strategist Global Investment Solutions Marc Schaffner Strategist Global Investment Solutions The views expressed are as of June 212 and are a general guide to the views of UBS Global Asset Management. This document does not replace portfolio and fund-specific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund. Copying any part of this publication without the written permission of UBS Global Asset Management is prohibited. Care has been taken to ensure the accuracy of its content but no responsibility is accepted for any errors or omissions herein. Please note that past performance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. This document is a marketing communication. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith. All such information and opinions are subject to change without notice. A number of the comments in this document are based on current expectations and are considered forward-looking statements. Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection of UBS Global Asset Management s best judgment at the time this document is compiled and any obligation to update or alter forwardlooking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Global Asset Management account, portfolio or fund. Services to US clients for any strategy herein are provided by UBS Global Asset Management (Americas) Inc., which is registered as an investment adviser with the US Securities and Exchange Commission under the Investment Advisers Act of 194. UBS 212. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. www.ubs.com 22226