Emerging markets: Countries and companies matter

Schwab Center for Financial Research Emerging markets: Countries and companies matter Anthony B. Davidow, CIMA Vice President, Alternative Beta and Asset Allocation Strategist

and other emerging market countries represent significant investment opportunities. There are also a number of risks, including geopolitical risks, economic uncertainty, currency fluctuations, and a lack of open and regulated financial markets. The challenge for investors is how to efficiently access these markets. 2 Anthony B. Davidow, CIMA Vice President, Alternative Beta and Asset Allocation Strategist, Schwab Center for Financial Research Anthony Davidow is responsible for providing Schwab s point of view on asset allocation and portfolio construction. He is also responsible for providing research and analysis on alternative beta strategies and how investors should incorporate them in their portfolios. Davidow is also a member of the firm s Asset Allocation Council. Before joining Schwab, Davidow was a managing director, portfolio strategist, and head of the ETF Knowledge Center for Guggenheim Investments. Before joining Guggenheim, Davidow was executive vice president and head of distribution for IndexIQ. Previously, he spent 15 years at Morgan Stanley, where he served as managing director and head of sales and training for the Consulting Services Group. While at Morgan Stanley, he worked with many of the firm s largest clients in developing and implementing asset allocation strategies, incorporating active and passive strategies, and using alternative investments as risk management tools. Davidow has authored several white papers and strategy pieces and spoken at industry conferences on a range of topics, including The Merits of Core-Satellite Investing, Asset Allocation and Manager Selection: Adaptive Allocation, Alpha-Beta Separation, Alternative Weighting Strategies, The Role and Use of Alternative Investments, Currency as an Asset Class, An Evolutionary Approach to Portfolio Construction, and Alternative Beta Strategies, among others. Davidow holds a B.B.A. degree in finance and investments from Bernard M. Baruch College and has earned the Certified Investment Management Analyst (CIMA) designation from the Investment Management Consultants Association (IMCA) and the Wharton School of the University of Pennsylvania. He served on the board of directors for IMCA from 2009 to 2014. He holds FINRA Series 7, 24, and 63 registrations.

In this paper We will explore the emerging markets and consider how investors can gain exposure to them. We will discuss the differences across the various markets and further evaluate the following: What are the differences among the various emerging market indexes? Do country allocations matter when investing in the emerging markets? Does it matter which companies you own? What are the key differences between market-cap and fundamentally weighted strategies that invest in the emerging markets? 3

Comparing the emerging markets Although emerging markets represent countries that are growing and may indeed become developed markets in the future, they are often at different stages of development. Their growth is affected by a number of factors, including geopolitical risk, import/export balance, natural resource access and exposure, demographics, and environmental factors. While various countries and economies are loosely grouped together as emerging markets, the economic growth and investment returns of the markets vary greatly from year to year. 4 In 2001, Jim O Neill, then chairman of Goldman Sachs Asset Management, published Building Better Global Economic BRICs. He argued that,,, and were at similar stages of newly advanced economic development and that their growth would dominate developed economies growth in the years to come. These countries and economies have been referred to as the BRIC countries, or the BRICs. Sometimes the acronym is modified to BRICS, which includes. Since the adoption of the BRIC moniker, a number of other acronyms have been used to describe similar growth opportunities, including MENA (Middle East, Northern Africa), MIKT (,, South, and ), and MINT (,, Nigeria, and ). Even though countries and economies may get grouped together, it is important to be aware that not all countries perform alike. Exhibit 1 shows the returns of various markets, as calculated using country-specific indexes, over the last several years. was the best-performing market in 2009 but has been in the middle to the bottom of the pack ever since, generating a double-digit negative return in 2014. Since 2009, there has been a different top-performing emerging market every year. was the top-performing market in 2012 (65.63%) and then dropped precipitously in 2013 ( 26.73%) before turning positive again in 2014 (18.93%).

After a negative return in 2013 ( 1.99%), rose from the middle of the pack to become the top-performing market in 2014 (29.14%). The point is that these markets are evolving, and good years are often followed by bad. Exhibit 1 The periodic table of emerging markets 2005 2007 2008 2009 2010 2011 2012 2013 2014 7.54% 65.63% 3.52% 45.74% 1.54% 44.93% -11.76% 30.61% -13.10% 28.97% -16.23% 20.80% -17.89% 19.98% -19.32% 19.96% -21.02% 18.21% -23.63% 17.57% -27.07% 15.73% -31.80% 11.57% -34.84% 9.56% -35.40% 1.47% 131.25% 82.88% 65.07% 61.76% 48.42% 45.89% 39.54% 31.86% Performance 2006 29.41% 25.79% 23.75% 19.76% 18.38% 16.21% 13.56% 10.37% 7.47% 5.85% 4.42% 187.86% 97.60% 85.26% 73.66% 58.03% 51.47% 47.89% 44.59% 43.05% 35.72% 33.94% 33.25% 32.12% 28.26% 25.49% 22.66% 15.12% 13.36% -4.30% 76.00% 72.86% 67.14% 58.39% 50.09% 48.52% 47.04% 45.07% 40.52% 33.70% 29.34% 22.02% 21.68% 21.37% 16.61% 13.08% 12.81% 8.63% 0.48% -34.62% -39.06% -39.28% -39.63% -43.72% -43.91% -46.78% -49.56% -53.30% -54.25% -55.33% -55.61% -56.43% -56.44% -57.66% -60.97% -61.57% -61.99% -72.29% 144.92% 123.13% 120.85% 118.33% 108.90% 95.12% 91.72% 90.70% 88.17% 78.44% 77.58% 76.08% 75.22% 68.88% 68.81% 65.97% 55.34% 50.76% 43.65% 69.74% 62.81% 57.00% 51.10% 49.23% 45.80% 45.18% 37.79% 33.49% 28.80% 27.35% 24.58% 24.00% 23.71% 23.68% 14.62% 5.95% 1.48% -9.06% -1.21% -13.46% -19.57% -29.64% -35.72% 43.87% 24.05% 18.52% 11.66% -1.99% 42.35% 12.13% 6.96% 4.56% 3.14% 0.65% -0.86% -0.92% -1.99% -2.30% -2.42% -4.11% -10.43% -15.83% -20.33% -21.55% -26.73% -26.83% -30.00% 29.14% 24.49% 22.95% 21.35% 19.06% 18.93% 15.49% 4.90% 1.16% -7.70% -8.74% -9.43% -9.89% -11.88% -13.44% -14.30% -25.56% -25.70% -42.12% Image source: www.usfunds.com. Data source: Bloomberg and U.S. Global Investors. Returns calculated in U.S. dollars. Past performance is no guarantee of future results. Indexes are unmanaged; do not incur management fees, costs, and expenses; and cannot be invested in directly. As the data in Exhibit 1 suggests, the emerging markets are a grouping of different countries at various stages of development. Some have an abundance of natural resources, and others are big consumers of natural resources. Some of these economies are importing goods and services, and others are exporting their goods and services. 5

6 Two hundred years ago, was the world s greatest power in terms of both economic muscle and geographical territory. Although s geographical boundaries have changed relatively little in the past two centuries, its economy suffered greatly under colonial exploitation and Mao s extreme economic policies. And yet, there is no question that will shortly surpass the United States and once again become the world s mightiest economic power. Burton Malkiel, From Wall Street to the Great Wall, 2008 When it comes to defining which countries are considered emerging markets, different firms or index providers might categorize the countries slightly differently. For example, Russell Indexes has divided the global equity markets into three categories: Developed Markets, Emerging Markets, and Frontier Markets. Emerging markets within Russell s classification system are characterized as having intermediate relative levels of macroeconomic risk as measured by characteristics that include, but are not limited to, the World Bank Income Classification (varying from Lower Middle Income to Upper Middle Income ), liquidity (moderate to high average daily dollar value traded), ease of local currency use (restrictions on the use of local currency), and intermediate relative levels of operational risk as measured by the strength of market infrastructure. The Next 11 (N-11), a term also coined by Goldman Sachs, are thought to be the next grouping of emerging economies, following the BRICs, to have a high potential for economic growth South,,,, Nigeria, Vietnam, the, Iran, Egypt, Pakistan, and Bangladesh. Additionally, there is another emerging market grouping that is gaining popularity for a different reason the Fragile Five. The Fragile Five refers to,,,, and. A 2014 Forbes article stated, For some time, there has been concern about the five emerging markets in particular:,,, and. These five are linked by vulnerability to current account and fiscal deficits. It s not just the deficit that is troubling, but the ability to service it and the availability of reserves. 1 The point is, not all emerging markets are created equal, and we should not assume the same outcomes for each market. Most investors lack the time and resources to properly evaluate the risks and return potential of each emerging market, which is why it is important to understand the different ways one can gain exposure to the emerging markets. 1 Chris Wright, After the Fragile Five, the Exposed Eight: The Bad News About BRICS and MINTs, Forbes, January 17, 2014.

Gaining exposure to the emerging markets Since the average investor would likely have a difficult time picking the best market in which to invest or the best companies in those markets, he or she might defer to an actively managed mutual fund that makes decisions about country allocations and individual companies to own. With the growth of exchange-traded funds (ETFs), investors have even more choices when it comes to investing in the emerging markets. They may choose to invest in countryspecific funds, BRIC funds, or broad-based emerging market funds. Emerging market ETFs and index-based mutual funds may provide a cost-effective way to gain broad-based exposure with different weighting methodologies. The traditional manner of gaining broad exposure to the emerging markets is through owning a market-cap-weighted mutual fund or ETF in which the largest companies have the largest weight. With the introduction of fundamentally weighted index strategies, investors can choose an alternative weighting methodology (see Fundamentally weighted indexing: Weighing the difference). Fundamentally weighted strategies screen and weight securities based on economic factors such as sales, cash flows, and dividends plus buybacks. This alternative weighting methodology sometimes leads to dramatic differences over time. 7 Exhibit 2 Top 10 stocks with weights Russell Fundamental Emerging Markets Large Company Index Index Weight Russell Emerging Markets Index Index Weight Samsung Electronics Co Ltd 4.27% Samsung Electronics Co Ltd 2.78% Gazprom OAO 3.12% Semiconductor Mfg Co Ltd 2.22% Lukoil OAO 2.46% Construction Bank Corp H 1.51% Construction Bank Corp H 2.45% Tencent Holdings Ltd 1.45% Mobile Ltd 2.36% Baidu.com Inc (ADR) 1.28% Semiconductor Mfg Co Ltd 2.00% Mobile Ltd 1.27% Industrial & Commercial Bank of H 1.98% Industrial & Commercial Bank of H 1.15% Bank of Ltd H 1.75% Naspers Ltd N Shs 1.10% Petroleum & Chemical Corp H 1.63% Alibaba Group Holding Ltd 1.01% HON HAI Precision Industry Co Ltd 1.51% Bank of Ltd H 0.96% Total 23.53% Total 14.73% Source: Russell Indexes. Data as of December 31, 2014. For illustrative purposes only. Holdings are subject to change without notice.

Exhibit 2 shows the top 10 holdings of the Russell Fundamental Emerging Markets Large Company Index and the Russell Emerging Markets Index. As the data shows, there are several similar names, but the weights of the holdings are different. The market-cap index gives the largest weights to the companies whose shares have the greatest value, regardless of their economic footprint. Samsung has the largest weighting in both indexes, but the reasons for the large weightings are different size versus fundamentals. Samsung has the largest weighting in both indexes, but the reasons for the large weightings are different size versus fundamentals. It s worth noting that n oil companies are the second- and third-largest holdings in the Russell Fundamental Emerging Markets Large Company Index (Gazprom 3.12% and Lukoil 2.46%). This is due in large part to their cheap valuations. With geopolitical risk in the region, their prices have fallen dramatically, making them attractive in the Russell Fundamental Index. They have much smaller weights in the market-cap index (0.49% and 0.37%, respectively). 8 Exhibit 3 Country allocations (%) Russell Fundamental Emerging Markets Large Company Index 15.19% 18.54% 23.01% Russell Emerging Markets Index 13.54% South 3.96% 10.48% 7.02% 18.72% 8.29% 3.09% 23.84% 12.95% 13.14% 7.34% 8.11% 12.78% Other Source: Russell Indexes, Russell Global Sectors (RGS). Data as of December 31, 2014.

Exhibit 4 Sector allocations (%) 5.05% 3.02% 6.17% 11.37% Russell Fundamental Emerging Markets Large Company Index 14.33% 21.86% 21.79% 16.41% 7.15% 7.42% 10.93% 9.30% 8.58% Russell Emerging Markets Index 2.71% 7.90% 27.37% 18.64% Source: Russell Indexes, Russell Global Sectors (RGS). Data as of December 31, 2014. Financial Services Technology Energy Materials & Processing Consumer Discretionary Consumer Staples Producer Durables Utilities Healthcare Exhibits 3 and 4 provide comparisons of country and sector allocations of the Russell Fundamental Emerging Markets Large Company Index and the Russell Emerging Markets Index. 9 As the data shows, the country allocations across the Russell Fundamental and Russell Emerging Markets indexes are quite different. The fundamentally weighted index overweights South,, and, and underweights and. The country allocations in the fundamentally weighted index are a by-product of its weighting methodology and are not intentional allocations. As the data in Exhibit 4 reflects, the fundamentally weighted index overweights Energy, Materials & Processing, and Utilities, and underweights Financial Services, Technology, Consumer Discretionary, and Consumer Staples. Again, the sector allocations are a by-product of the weighting methodology. The differences in their methodologies lead to differences in the weighting of securities, sectors, and country allocations. There are substantive differences between the Russell Emerging Markets Index and the Russell Fundamental Emerging Markets Large Company Index. The differences in their methodologies lead to differences in the weighting of securities, sectors, and country allocations. They may also lead to divergent returns over time.

Conclusion The emerging markets offer both opportunities and risks. Although certain countries are often grouped together, each country has its own distinct set of factors that drive its economy. Emerging countries may be at varying stages of development and may experience dramatically different returns over time. Not all emerging markets will provide the same ride. 10 Investors have choices in how they gain exposure to different markets. They can own individual securities or gain exposure to individual countries through country-specific investments. They can buy mutual funds or ETFs, and they can own market-cap or fundamentally weighted index strategies. Regardless of the way an investor gains access to the emerging markets, it is important to recognize that different factors such as commodity prices, economic development, and political instability can affect each emerging economy differently. These differences can lead to dramatically different risks and returns for each economy. An investor should be mindful of these differences and should take a thoughtful and diversified approach when investing in the emerging markets. Rather than simply weighting securities based on market value, fundamental strategies weight securities based on economic factors such as sales, cash flows, and dividends plus buybacks. With this thoughtful approach, fundamental strategies have historically delivered distinctive and compelling returns over time. When investing in emerging markets, country allocations and company weightings can have a significant impact on the return achieved.

Glossary of terms Fundamentally weighted index. A type of equity index in which components are chosen based on fundamental criteria as opposed to market capitalization. Fundamentally weighted indexes may be based on fundamental metrics such as sales, cash flow, and dividends. Proponents of these indexes claim that by selecting and weighting companies according to economic size, they avoid market capitalization indexes systematic overweights to richly valued companies and their underweights to companies with low valuation. Fundamentally weighted indexes are sometimes referred to as alternative beta, strategic beta, or smart beta. Market-cap-weighted index. Most of the broadly used market indexes today are cap-weighted indexes, such as the S&P 500, Russell, and MSCI indexes. In a cap-weighted index, large price moves in the largest components can have a dramatic effect on the value of the index. Some investors feel that this overweighting toward the larger companies gives a distorted view of the market. Russell Emerging Markets Index. The Russell Emerging Markets Index measures the performance of the investable securities in emerging countries globally. The Russell Emerging Markets Index is constructed to provide a comprehensive and unbiased barometer for this market segment and is completely reconstituted annually to accurately reflect the changes in the market over time. 11 Russell Fundamental Emerging Markets Large Company Index. The Russell Fundamental Emerging Markets Large Company Index ranks and weights large emerging markets companies by three fundamental measures of company size adjusted sales, retained operating cash flow, and dividends plus buybacks rather than by market capitalization. Fundamental scores are created using the members of the Russell Emerging Markets Index. Securities are ranked by each fundamental factor, and individual factor weights are averaged to determine overall fundamental weights. The Russell Fundamental Emerging Markets Large Company Index is composed of the top 87.5% of the Russell Fundamental Emerging Markets Index. Once the index has been created, it is rebalanced quarterly.

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