A different route FOR PROFESSIONAL CLIENTS ONLY Accessing emerging market growth via developed market beta by TIMOTHY MURRAY CURRENTS JULY 2013 ISSUE
BETA STRATEGIES TIMOTHY MURRAY Product strategist within BlackRock s index equity portfolio management group. Using developed market equities to access emerging markets may increase liquidity, reduce transaction costs and shorten time to market. The case for investing in emerging markets is a strong one, and not just for portfolio investors. Many of the developed world s leading companies have built big footprints in the fastergrowing parts of the globe and now derive significant portions of their revenue from them. Can portfolio investors get meaningful exposure to growth in developing countries by buying stock in these companies? We believe they can, and we think that new beta strategies now becoming available may be good vehicles for investors wishing to travel this route. Globalisation is a familiar phenomenon, but it s still easy to underestimate its effects including the way it has transformed corporate revenue streams. FIGURE 1: WHICH IS THE EMERGING MARKET COMPANY? Geographic sources of revenue for Unilever and Samsung Unilever 100% 80 60 40 20 0 Samsung 1996 In 1996, for example, Samsung Electronics collected 60% of its revenue from its home country, South Korea. But by 2012, that portion had decreased to only 16%. 1 While this was happening, Unilever, the Dutch consumer products giant, was dramatically increasing sales of its soaps and snacks in the developing world. In the years spanning 1996 to 2012, the portion of Unilever s revenue derived from Asia and Africa nearly doubled, from 20% to 38% 2 (see figure 1). Revenue shifts such as these lead to an important point: these days, a company s country of domicile provides little information about where it actually does business. 2006 Europe Americas 2012 Asia and Africa 100% 80 60 40 20 0 1996 2006 2012 Europe Americas Asia and Africa Korea Source: MSCI, February 2013. 1. Source: MSCI, February 2013. 2. Source: MSCI, February 2013. 2 CURRENTS Unless otherwise specified, all information contained in this document is sourced by BlackRock and is current at 30 June 2013.
The sector tilt may give investors superior exposure to some major investment themes. FIGURE 2: EMERGING MARKET BETA AT BLACKROCK Exchange Traded Funds 59.8% Commingled Trust Funds 27.2% Separate Accounts 12.1% Other Pooled Funds 0.5% Mutual Funds 0.4% Source: BlackRock, April 2013. And since most benchmarks use country of domicile to split companies between developed and emerging categories, traditional passive strategies may include many hidden exposures. Samsung s case is far from unique. Embraer, the Brazilian aircraft-maker, generated over half its 2012 revenue in Europe and North America, according to the company s annual report. For Infosys, the Indian IT services provider, European and North American revenue was 85% of the total in 2012, according to its annual report. WHY EM BETA IS BIG There are certainly good reasons why traditional market-capitalisationweighted beta strategies have long been the most popular way to gain access to emerging markets. They address three common problems in emerging market (EM) investing: ``High trading costs, which make low turnover strategies more attractive. ``A lack of transparency at the market and company levels, which makes a broadly diversified strategy appealing. ``Difficulty of access, which makes a quick path to exposure desirable. These advantages have enabled traditional EM beta strategies to attract a huge amount of capital. For example, BlackRock has seen assets in its EM beta strategies grow to nearly $201 billion in a variety of vehicles 3 (see figure 2). While the appetite for traditional marketcap-weighted EM strategies remains strong, interest in alternative beta strategies has also been on the rise, as it has been elsewhere in the beta universe. Fundamentally weighted and minimum volatility strategies have quickly captured investors attention. And so too has the idea of securing EM exposure with developed market equities. Both MSCI and Russell launched their exposure-based index series in 2012. Today, there are more than 20 benchmarks available between the two providers, including exposures targeting broad markets (eg emerging markets), regions (eg Asia), and even specific countries (eg China). 4 Although very few assets are currently managed to these benchmarks, this may change in the near future. EM exposure benchmarks offer many benefits. They can diversify local EM equity beta exposures, solve maximum local EM equity holdings constraints, and reduce corporate governance concerns. From an implementation perspective, using developed market equities to access emerging markets may also increase liquidity, reduce transaction costs and shorten time to market. In brief, investors receive the benefits of developed market regulations, structures, and efficiencies, while accessing EM growth possibilities. 3. Source: BlackRock, April 2013. 4. Source: MSCI and Russell. 5. This is a general account of benchmark construction methodologies and does not represent any particular provider s methodology. 3 CURRENTS Unless otherwise specified, all information contained in this document is sourced by BlackRock and is current at 30 June 2013.
Swapping systemic risks from emerging to developed markets might not always be beneficial... FIGURE 3: LIGHT ON BANKS, HEAVY ON TOOTHPASTE Relative weight by sector for MSCI s World with EM Exposure Index vs MSCI Emerging Markets Index 20% 10 0-10 -20 Financials Telecom Utilities Energy Health care Information technology Consumer Materials discretionary Industrials Consumer staples Source: MSCI, as at 28 February 2013. BUILDING THE INDEXES Simply stated, EM exposure-based benchmarks are constructed with developed market equities that generate a significant portion of their revenues from EM countries. The methodology 5 starts with determining the economic exposure for each company within a parent index, which is calculated by multiplying the percentage of the company s revenue derived from emerging markets by the company s market capitalisation. Given that some companies segment their revenue sources into superregions containing both developed and developing economies (eg Europe, Middle East and Africa and Asia- Pacific ), the challenge is to reliably track EM revenue. The providers have differing methods for accomplishing this. MSCI, for example, allocates revenues to countries based on their GDP weightings within the region, whereas the STOXX Global EM Exposed Index uses country-to-country export data compiled by the United Nations. No method is perfect, but in our view all are effective. Reassuringly, all of them also yield fairly similar results. Next, the companies are sorted in descending order of their economic exposure value and placed into the index until the target number of companies is reached. Finally, the weight of each constituent is modified to conform to any practical diversification rules. The resulting benchmark contains a group of developed-market equities with a generous exposure to emerging markets. How does the exposure-based benchmark compare to the local emerging markets index? Interestingly, one could argue that the sector tilt may give investors superior exposure to some major investment themes. As seen in figure 3, the exposure-based benchmark ends up underweight financials, telecoms, utilities and energy. These sectors are often designated by local regulators as being critical to the national interest, and are limited in terms of foreign investment. By contrast, the exposure-based benchmark yields overweights in sectors like consumer staples, consumer discretionaries, industrials and materials. As per-capita income rises in emerging markets, people are expected to consume more goods, and these sectors stand to benefit. This makes exposure-based benchmarks a potentially useful tool to express investment views that tap into themes such as urbanisation and infrastructure growth (see figure 4). 5. This is a general account of benchmark construction methodologies and does not represent any particular provider s methodology. 4 CURRENTS Unless otherwise specified, all information contained in this document is sourced by BlackRock and is current at 30 June 2013.
FIGURE 4: WHAT S IN THE INDEX? Top 10 constituents (MSCI World with Emerging Markets Exposure Index) Stock Name Weight Apple 5.1% BHP Billiton Ltd 2.4% Nestlé 3.1% HSBC Holdings (GB) 2.3% Qualcomm 3.0% Intel Corp 2.2% Philip Morris Int 2.6% British American Tobacco 1.9% Procter & Gamble Co 2.5% Vodafone Group 1.8% Source: MSCI, February 2013. As the saying goes, even a good garden has some weeds, and the same is true of exposure-based benchmarks. Namely, investors should be aware that swapping systemic risks from emerging to developed markets might not always be beneficial. One has to look no further than the recent European financial crisis to understand this point. Furthermore, exposure-based benchmarks represent very different currency exposures and risk premia than a benchmark of local securities. EM returns that are attributed to these factors will be sacrificed when using developedmarket equities to obtain EM exposures. As globalisation continues, gaining EM exposure through economic-exposure benchmarks may prove especially attractive for investors trying to diversify EM return streams or for those with policy constraints on local EM exposure. By moving beyond traditional index rules that define country classification, these benchmarks represent a different route to EM exposure as well as a chance to extend the EM opportunity set. Although we expect the adoption of these benchmarks to take time, we anticipate that they will play an increasingly important role in future emerging markets allocation decisions. 5 CURRENTS Unless otherwise specified, all information contained in this document is sourced by BlackRock and is current at 30 June 2013.
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