TO:
South Carolina State Firefighters’ Association
FROM:
S. Bart Valley, Cheryl R. Holland, Charles B. Flowers
DATE:
June 22, 2007
SUBJECT:
Emerging Markets Investment Recommendation
One of our duties in managing your portfolio is to consider a broad spectrum of potential
asset classes for inclusion in your investment plan. As you know, our investment and
management decisions with respect to individual assets or asset classes are evaluated not in
isolation, but rather in the context of your portfolio as a whole and as a part of your overall
investment strategy. We seek out asset classes whose inclusion should increase overall
portfolio return, reduce overall portfolio risk, or a combination thereof.
Towards this end, we believe that the inclusion of emerging markets stocks in your portfolio
will serve to enhance performance over the long-term. Emerging markets stocks are the
equities of companies within emerging, or developing, international economies. Emerging
markets form the tier of economies just below the developed economies. Emerging stock
markets, generally in middle-income economies, are stock markets in transition—increasing
in size, activity and level of sophistication. Taiwan, Mexico, Israel, Turkey and Brazil are all
examples of the approximately 30 countries currently classified as emerging markets. The
benefits of investing in these and other emerging countries include high expected returns,
portfolio diversification, and exposure to a broader opportunity set of investments.
The most compelling reason for including emerging markets stocks in your portfolio is their
potential for high rates of return. Reliable returns data on emerging markets is available back
to January 1988, and from that point through year-end 2004, emerging market stocks have
posted average annual returns of 17.45%, versus 12.39% for US large-capitalization stocks
over the same period.1 Emerging markets typically show trendline rates of economic growth
above those of developed markets. This faster economic growth traditionally translates into
higher growth in corporate earnings and hence higher equity market returns over time. As
emerging economies successfully develop, they enjoy above-average long-term stock returns.
Other advantages that boost the performance of emerging markets over time include the
upward pressure exerted by desire for improved standards of living, the possibility for rapid
development through new technologies, competitive advantages such as low labor and
resource costs, and an expanding consumer base. These factors in aggregate enhance the
international competitiveness of these developing countries, benefiting corporate profit
growth and equity market returns. As you can see in the chart on the following page,
cumulative returns in emerging markets stocks have been quite exceptional when compared
with traditional US stock and bond performance.2
Cumulative Returns: Jan 1988 - Dec 2004
1600.00
US Large Stocks
US Small Stocks
Emerging Markets
US Bonds
Percent Returns
1400.00
1200.00
1000.00
800.00
600.00
400.00
200.00
1/04
1/03
1/02
1/01
1/00
1/99
1/98
1/97
1/96
1/95
1/94
1/93
1/92
1/91
1/90
1/89
1/88
0.00
Time Periods
In addition to their excess return potential, emerging markets stocks also bring significant
diversification to the portfolio. The correlation between emerging markets stocks and US
large-cap stocks from 1988 through 2004 has averaged only 0.54, meaning the addition of
emerging markets stocks can actually serve to lower total portfolio volatility over time.
Furthermore, emerging markets show only a 0.50 correlation to international developed
country stocks, meaning they are providing a very different exposure than traditional
international investments, further enhancing portfolio diversification. Because forces that
drive markets differ from country to country, market returns also vary significantly from one
emerging market country to another, bringing the opportunity for diversification within the
asset class as well.
Emerging markets also provide an expanded set of attractive investment opportunities.
Again, these are countries with absolute advantages such as cheap raw materials and low
labor costs. Coupling these advantages with rapid diffusion of productivity-enhancing
technology enables emerging market companies to increase returns on equity. Investors thus
benefit from the ability to select among a broader set of strong-performing companies. These
opportunities run from oil and mining companies to pharmaceutical companies to wireless
telephone companies. Familiar emerging markets names include Samsung Electronics, Teva
Pharmaceuticals, Petroleo Brasileiro and Wal-Mart de Mexico. There are a large number of
world-class companies across these markets that are well positioned to benefit from rapidly
growing and changing economies.
It is important to note that emerging markets investment do contain significant and unique
risks. One of the most important is political risk. External conflicts, racial and national
tensions, corruption and changing government policies can create political instability that can
have negative effects on firms’ ability to generate earnings growth and stock market returns.
Economic policies and/or reforms may fail at times, creating a challenging environment for
corporate operations. Also important is the risk around the regulatory and operational
environments in these emerging countries. The quality of market regulation, corporate
governance and accounting standards is often below that of developed countries, making it
more difficult to appropriately price securities.
These and other risk factors lead to a significant amount of volatility in emerging markets
investments. Investors must understand that high rates of return are naturally accompanied by
higher levels of risk. There will be periods when emerging markets investments significantly
underperform other less risky assets in your portfolio. However, this volatility needs to be
understood in the context of your larger portfolio. At a target 4% weighting, the higher rates
of return and diversification benefits offered by emerging markets exposure should serve to
enhance the long-term risk-return characteristics of your overall portfolio.
The vehicle we will be using to gain emerging markets exposure is the Dimensional Emerging
Markets fund. This fund invests in a broadly diversified portfolio of more than 500 large
company stocks across 15-20 top-tier developing nations. Since correlations among emerging
markets are low, this diversification significantly reduces the volatility inherent in an
emerging markets portfolio by reducing specific exposure to the aforementioned risks. As of
year-end 2004, the Dimensional portfolio’s top five country weightings were Taiwan,
Mexico, Korea, Israel and South Africa. Dimensional also attempts to reduce volatility by
excluding certain emerging countries where risks may outweigh potential rewards.
Information disseminated by the International Finance Corporation is an important tool in
their consideration and approval of countries to be included in the portfolio.
The rationale for investing in emerging countries comes primarily from our expectations of
superior long-term returns over time, and secondarily from the opportunity for risk reduction
through diversification. Prudent investment in these countries that are experiencing
substantial economic growth and rapid expansion of investment opportunities brings
significant benefits to your investment portfolio. The inclusion of emerging markets
investments will further enhance your portfolio’s ability to withstand ever-changing global
conditions, and to thrive in a variety of economic and market scenarios.
1
Emerging markets measured by the DFA Emerging Markets Index. US large-cap stocks measured by the S&P
500 Index.
2
US large-cap measured by the S&P 500 Index. US small-cap measured by the CRSP 9-10 Index. Emerging
markets measured by the DFA Emerging Markets Index. US Bonds measured by the Lehman Brothers
Intermediate Government/Credit Index.