INVESTING IN EMERGING
EQUITY MARKETS
COLORADO PUBLIC EMPLOYEES RETIREMENT
SYSTEMS FORUM
May 8, 2007, Denver, Colorado
Professor Michael Palmer
Leeds School of Business
University of Colorado at Boulder
Michael.Palmer@colorado.edu
Goal of this Presentation
To offer some insights into the
emerging market phenomenon, and
To discuss some practical issues
involved in constructing a globally
diversified portfolio with emerging
market equities.
Global Portfolios
Investors have long been aware of the
potential benefits of adding foreign stocks to
a portfolio.
Basically, international diversification can
reduce the risk and increase the return
expected from a single market portfolio.
The topic for us today is what are the issues
in using the emerging markets for this
purpose.
How Does Diversification Work?
Global diversification works if equity
markets in different countries don’t
move together much.
So as long as economic, political,
institutional, and psychological factors
affecting security returns vary across
countries, stock markets will show
relatively low correlations.
But, what does the emerging market
picture look like?
Correlation of Emerging Markets to US
First Practical Issue
Bad News: Overall, emerging markets are
more closely related to the US market now
than years ago.
This was to be expected as these emerging
countries lifted their capital controls and became
more integrated in the global economy.
We can conclude then that achieving diversification
benefits with emerging markets is more difficult
today.
Good News: Correlations are not perfect; thus
diversification benefits are still possible.
Next Issue. What About Returns?
Long Run Returns:
From January 1988 to December 2006,
emerging country stock markets have
recorded an annualized return of 14.8% in
US dollar terms.
Last Four Year Returns:
For the four years ended December 31,
2006 emerging markets delivered an
annualized return of 36.4% a year in US
dollar terms.
Returns in 2006 and 2007
In 2006 alone, the MSCI Emerging Markets
Index rose 30%, led by an extraordinary 77%
average gain in its four biggest countries —
Brazil, Russia, India and China!
In 2006, the Shanghai Composite Index
posted a 128% gain, making it the “star
performer” among equity markets.
Thus far in 2007, the Shanghai Index
continues to lead with a gain of 77%
How Do Emerging Market Returns
Compare to Developed Markets?
Summary of Returns
Over various periods of time, emerging
markets as a group have delivered
relatively high annualized returns.
Many emerging markets have exhibited
superior annual return performance
relative to the US market.
But what about the volatility (i.e., risk)
of emerging market returns?
Comparison of Market Volatility
Emerging Markets
Annual return
Standard deviation
S&P 500
Annual return
Standard deviation
Last 3 years Last 5 years
24.45%
21.46%
17.71%
18.11%
10.06%
6.27%
6.95%
12.29%
Standard deviation is a measure of an investment’s past volatility.
The higher the standard deviation, the greater the volatility.
Second Practical Issue
Good News: Emerging markets have
offered higher returns than the United
States.
Bad News: BUT, with greater volatility
(i.e., greater risk).
Potential Good News: Greater volatility
means there is the potential on the
upside for big returns.
Next Issue: So What are the Best (?)
Models for Selecting Emerging Markets?
Studies show that for emerging markets,
country performance is by far the biggest driver
of equity returns — far exceeding sector and
company performance.
“In any given year, the worst stocks in the
best-performing countries tend to outperform
the best stocks in the worst performing
countries.”
So, we should focus on the COUNTRY when
investing.
What Should We Focus On?
Political Risk: Sudden changes in the political
environment of the host country.
Thailand last year, Turkey last week.
Globalization Risk: Changes in the overseas
markets that a particular country is
dependent on.
Who’s vulnerable to a slowdown in the US
economy? Hong Kong, Singapore, Venezuela,
Mexico, and Malaysia appear to be the most
vulnerable as their exports to the United States
make up more than 20 percent of their gross
domestic product.
And More …
Inflation Risks: Equity investors do not
like high and rising rates of inflation.
Examine each country’s inflation pressures.
• Chile, Turkey, Russia today.
Interest Rate Risks: Equity investors do
not like high and rising interest rates.
What is each country’s central bank doing.
• Chile, Turkey, Brazil, and Russia today.
Third Practical Issue
Bad News: Unfortunately, the emerging
markets comprise a very diverse set of
countries with profoundly different
political, economic, cultural, and
regulatory regimes. This makes
following them difficult.
Good News: If you do get the country
right, you probably don’t have to worry
about companies and sectors.
Last Issue: Exchange Rates
Since you are based in the United
States, you are ultimately concerned
with the US dollar return on your
emerging market investment.
Question? Do exchange rates have an
impact on your emerging market
returns?
Answer: Definitely, YES
Specific Emerging Market Examples
in 2007 (Through 4/25)
Country
China
Local Currency U.S. Dollar
Return
Return
58.4%
60.2%
Brazil
11.7%
17.1%
India
3.1%
11.6%
Russia
0.2%
2.7%
Mexico
11.3%
10.2%
Venezuela
-8.7%
-9.6%
Fourth Practical Issue
Bad News: If the value of the foreign
currency of the emerging market country
declines against the US dollar, your return will
be lower (Mexico and Venezuela in 2007).
Good News: If the value of the foreign
currency of the emerging market country
increases against the US dollar, your return
will be higher (the big 4 in 2007).
Very Bad News: Forecasting exchange rates
is almost impossible.
Fourth Practical Issue
More Good News: Some countries
manage their currencies in relation to
the dollar, so these currency rates are
relatively stable (Hong Kong, Saudi
Arabia, to some extent China).
More Bad News: More and more
countries are moving away from
managing their currencies in relation to
the US dollar.
China in 2005.
Where Do We Go From Here?
Over the past decade, institutional investors - pension funds, foundations, and
endowments -- have increased their emerging
market allocations.
However by all measures, emerging markets
are still underweighted in institutional
portfolios.
Question: Is expanded investment in
emerging markets justified?
Answer: Probably yes.
Final Word on Emerging Markets
In the future, emerging market investments
should continue to offer higher potential
returns to investors but additionally with the
potential for greater risk and greater
volatility.
And, while emerging markets are probably “in
better shape than they’ve ever been,” the
8.8% plunge of China’s Shanghai Composite
index on February 27th of this year, which
dragged down emerging and developing
markets alike, was a timely reminder of this
risk and volatility.
APPENDIX 1:
WHAT ARE EMERGING
MARKETS?
Emerging Markets: What Are They?
The term "emerging markets" was coined by
the World Bank's International Finance
Corporation in the early 1980s.
Typically, emerging markets are in countries
that:
are in the process of industrialization, and
Have lower per capita gross national product
(GNP) than the more developed countries.
Of the 130 countries that the international
financial community generally considers to be
emerging or developing countries,
approximately 40 currently have stock
markets.
APPENDIX 2:
A LOOK AT GLOBAL
DIVERSIFICATION
Do Security Returns Vary Across
Country?
In the 1970s, when the investing world
began to discover the benefits of global
diversification, security returns showed
little correlation.
1973-1982 Data; US Stock Market to:
German Market: 0.170
Japanese Market: 0.137
United Kingdom Market: 0.279
Late 1980s and into the 1990s
During this period, stock returns across
markets started to show a greater relationship.
Driven by the globalization process.
First evidence: October 1987 global stock
market crash when most developed markets
declined together.
1980-2000 correlation data of US markets to:
German market: 0.45 (0.170 for 1973-1982)
Japanese market: 0.31 (0.137 for 1973- 1982)
United Kingdom market: 0.58 (0.279 for 1973 1982)
What Does It Look Like Now?
APPENDIX 3:
YEAR TO YEAR
(IN)CONSISTENCY AMONG
THE EMERGING MARKETS
Emerging Market Consistency
STOCK EXCHANGE
% Change 2005/2004
(in USD)
Egypt
146.4%
Columbia
126.3%
Saudi Arabia
113.2%
Russia
83.3%
Turkey
67.1%
Korea
62.3%
Pakistan
57.4%
Brazil
53.4%
Mexico
52.2%
India
42.0%
Emerging Market Consistency
STOCK EXCHANGE
% Change 2006/2005
(in USD)
China
138.4%
Venezuela
99.0%
Indonesia
73.1%
Russia
70.7%
Poland
61.4%
India
51.3%
Mexico
47.8%
Brazil
45.2%
Singapore
40.4%
South Africa
24.9%
Emerging Market Consistency
STOCK EXCHANGE
% Change 2007 (4/25)
/2006 (in USD)
China
60.2%
Turkey
30.9%
Poland
24.1%
Malaysia
23.8%
Pakistan
21.6%
Brazil
17.7%
Czech Republic
16.6%
Chile
15.6%
South Africa
14.4%
Singapore
14.1%
APPENDIX 4:
IMPACT OF EXCHANGE
RATES ON US DOLLAR
RETURNS
Exchange Rates Impact in 2006
Region
Americas
2006 Return in 2006 Return in
Local Currency US dollars
16.8%
17.0%
Asia-Pacific
24.6%
33.8%
Europe/Africa/ 19.5%
Middle East
Average
19.1%
27.1%
23.8%
Exchange Rates Impact in 2005
Region
Americas
2005 Return in 2005 Return in
Local Currency US dollars
7.6%
8.2%
Asia-Pacific
27.2%
18.3%
Europe/Africa/ 23.6%
Middle East
Average
16.0%
8.1%
10.0%
APPENDIX 5:
THE CASE FOR EMERGING
MARKETS
History of Emerging Markets
In the late 1980s, emerging markets became
the new frontier of global investing.
In the early 1990s, these markets exhibited
spectacular returns, only to be followed by an
exceptionally long span of volatile and
disappointing results.
During the 1990s these markets moved from
one crisis to the next:
the Mexican peso devaluation of 1994.
the Asian financial crisis of 1997-1998,
and the Russian ruble devaluation and debt
default of 1998.
Argentina debt crisis of 2000
The Case for Emerging Markets
Today
1. Economic growth: Emerging markets are
growing much faster than the developed
countries in North America, Western Europe,
and Asia.
Over the ten-year period ended December
2005, emerging countries’ average annual
growth rate was 5.5%, which was more than
double the 2.7% growth recorded by
developed countries during the same period.
Economists expect this growth trend to
continue for the foreseeable future.
The Case for Emerging Markets
Today
2. Inflation has been on a downward trend in
emerging markets for some time now.
Within this group. measured inflation has halved
from the double digit numbers seen in the late
1990s.
Low inflation supports a continuation of high
growth environment in the emerging
countries.
The IMF forecasts are for inflation to remain
low.
The Case for Emerging Markets
Today
3. Interest Rates: Interest rates in the
emerging countries has trended down.
The interest rate spread (which is a measure
of risk) on emerging markets bonds has fallen
significantly in the last five years from more
than 1000 points to about 200 points today.
The fall in rates and spreads is due primarily
to low inflation and stable monetary policies.