Emerging markets: from satellite to core investment

Yuri Bender: Our aim today is to achieve some sort of consensus on emerging markets investing:

• Are these opportunities suitable for all private clients?
• Should they be at the core of their portfolios?
• What is a suitable type of allocation?
• How do we select the correct managers?
• Is there a big difference in quality between the funds being launched?

Yuri Bender: It appears to be perceived wisdom these days that emerging markets should be very much at the core of private-client portfolios rather than the satellite bets of old. Bill O’Neill, how do you expect this story to play out, pitching emerging against developed markets?

Bill O’Neill: The touchstone of developments on the emerging-markets side, until recently, was the development of the Chinese economy, which suggests at this stage the market is overheating. Where China goes economically will, rightly or wrongly, have a significant effect on where emerging markets go in the next year. The argument is that the Chinese economy is expanding above its productive potential. It will be interesting to see, once the currency adjustment comes through, what the impact of that is on the emerging-market bloc overall, and the extent to which basic bank lending is restricted from here.

However, the argument at the moment, certainly in terms of emerging markets broadly speaking, is, ‘Where do you want to set the allocation?’ The MSCI All Countries World Index (ACWI) is currently 11-12 per cent of total global equities. Do investors feel happy with that as a reference point for overweight?

Broadly speaking, the current thinking is that there is a risk premium on these assets. Looking at valuations relative to developed markets, they are somewhat ahead in terms of PE ratio versus where they would have been as an average of the past 20 years. The pessimists would say, “There is a reason for this sector being on a discount”, this reason being higher volatility, which suggests the quality of earnings is less and, therefore, the multiple applied should be lower.

That fails to grapple with the idea that, ultimately, for the foreseeable future, the emerging market bloc will be the engine of growth in the world in an environment where control over inflation is a key prerequisite. However, if it is seen to have control over inflation and there is a situation where, as a result of that and other technological developments, productivity continues to be enhanced in these economies, and labour and resources are used more sensibly, why should that share of total equity not expand?

There is, then, that idea of volatility combined with the convergence view that stock markets for this bloc, as a share of GDP or by using the various metrics, are ‘under capitalised’ in terms of equity and, consequently, they should expand. That is the convergence theme relative to, say, the position of the US economy. However, there is a sense that the volatility issue has been put to one side, simply because of the amount of liquidity that has been surging through the economy.. At the same time, however, there is a sense that the volatility issue has been put to one side, simply because of the amount of liquidity that has been surging through the economy, certainly since the onset of the financial crisis.

Jeremy Beckwith: If you look at the three key elements of portfolio theory - returns, risk and correlations, then a higher weight of emerging markets makes strategic sense from a portfolio construction perspective. The returns in emerging markets are likely to be higher than in developed markets. The risks from emerging markets are coming down as countries become more developed and increasingly, we are seeing the correlations beginning to diverge, because many of these countries are now going down different paths and specialising in different parts of the economic value chain.

Marco Giubin, Mirae Asset Global Investment Funds

Yuri Bender: Some economists are arguing the optimistic outlook for emerging markets equities is overplayed and that there is not enough evidence when examining valuations to suggest they will outperform developed markets. Despite huge inflows in 2009, do we feel returns from emerging markets will be no better than their developed-economy counterparts in the short to medium term?

Richard Carlyle: I would like to see the valuation numbers they give, because we have emerging markets at about 14 per cent of the ACWI, but they are about half of world GDP, 70 per cent of the world’s population and 90 per cent of the world’s oil reserves. They are an impossible area to neglect. Our view is that, relative to developed economies, they seem less risky now than they were. They have stronger trade surpluses, better government finances, and often higher credit ratings than some developed economies.

We use price/cash earnings as the simplest way of measuring the valuations currently or over history, and they are at a minuscule PE premium to developed countries, yet the growth drivers, be it China, urbanisation or people just wanting better living standards, seem inexorable to us. We do not, therefore, think that higher valuations suggest everything is discounted. It is not preposterous that emerging markets should be on a 15-20 PE premium to developed markets.

You have to accept, however, that, historically, they have been more volatile, and if developed equity markets fell 10 per cent, emerging markets would probably fall 15 per cent, for whatever the reason, but is that right going forward? It does not seem so to me. I think that the 14 per cent of the ACWI they represent should be a minimum. It is difficult to find reasons why you would have less than the market cap-weighted percentage of emerging markets in your portfolio on a long strategic view.

Amin Rajan: There is mixed evidence about how emerging markets have done, depending on the time period you look at. Research from London Business School, going back to 1975, shows no relationship between GDP growth and stock prices: besides, they’ve had an underperformance of about 100 basis points a year on average since 1975. The idea of economic decoupling between the East and the West is over simplistic. Looking at trade between the US and China, decoupling has not occurred, once you consider the multiplier effects. China sells to someone who sells to someone else, who in turn sells to the US, and so on. The multiplier effects are subtler now. If we concentrate on China, many big stocks are overvalued. The Chinese equivalent of Google has a PE ratio of about 200. China’s oil company, with more or less the same market cap as Exxon, generates less than half the revenue. There is a view that stocks are grossly overheated and there may be adjustment. There are short-term opportunities, but in the long-term things can go wrong. Many of these factors are concealed by pure numbers. So¸, people do have significant worries..

Paul Marson: There is a real parallel between emerging markets and commodities. Most fund managers, when allocating assets, use some form of mean variance optimisation model. We all know about the failings of the assumptions underlying mean variance optimisation, one of which is the shape of the probability distribution of returns for the asset class.

With emerging markets like commodities, the return distribution does not look anything like what is needed for it to have a strategic weighting and a strategic benchmark allocation. Most managers used to see it as a tactical asset for those very reasons. Then the commodities and emerging markets rallied dramatically, so many fund managers are putting it in a strategic weighting now, for no better reason than the fact that they are under pressure from their clients, and competitive commercial pressure, to put it in. In effect, then, it has entered their portfolios for really quite the wrong reasons.

I would like to parallel what Amin just said with a great quote from Thomas Huxley, the 19th century biologist, who said, “The great tragedy of science is the slaying of a beautiful theory by an ugly fact”. It is a beautiful theory that growth matters, but the simple experience of investors is that it does not. The cross-sectional correlation between economic growth and developed-country equity returns for a century is negative. In the post-war period, it is zero.

Within emerging markets, research by Peter Blair Henry at Stanford again shows that cross sectional correlation between growth and return in emerging markets is negative. The cross sectional return between emerging and developed is that emerging markets have typically always underperformed. The same thing applies in demographics. Angus Maddison, in his Millennial Perspective, shows the outlook for equity returns is negatively correlated with population growth. Many urban myths have grown up in investing, which are not borne out by empirical evidence.

Yuri Bender: How do you represent these views in your clients’ portfolios?

Paul Marson: We have no emerging market equity in our portfolio, because I find it difficult to justify allocating to emerging markets when they trade at a valuation premium and when I know the cross sectional return correlation to growth is negative.

It goes back to where I started: many fund managers have commodities and emerging markets in their portfolio for no other reason than they have been forced to play catch-up. They missed the rallies in both commodities and emerging markets because these classes were not strategically in their benchmarks. The clients became very upset they were missing the returns being achieved in these two asset classes, so they have been forced to push it into the portfolio. Putting something into the portfolio for those reasons is fundamentally an incorrect reason.

Yuri Bender: Marco, we started off with what seemed like a ‘love-in’ with emerging markets, and now it has almost gone full circle. What is your view: a core investment or a diversification opportunity?

Marco Giubin: I would see emerging markets, and particularly Asian markets, as more of a core investment than a diversification tool necessarily, as they are a phenomenal long-term opportunity. During the last ten years, there has been a big improvement in corporate governance and companies’ attitude towards shareholders. It is still not as good as in developed markets, but is definitely on the right track.

If you look at the PE or price to-book ratings over the last 10 years, there has been some rerating, but you have to put that up against the fact that balance sheets and gearing ratios have fallen off the cliff. Most corporates do not have aggressive balance sheets; neither do individuals. I would argue the growth we see can be financed through savings, particularly on the consumer side, where savings rates in China are at more than 50 per cent. So we are still bullish on domestic consumer stories.

When you are looking at emerging markets, there is a huge variance of returns within the bracket. Within China or the different countries, you may see what the return is, but some stocks can massively outperform and others can massively underperform, which is why we think it is quite important to have a presence in Asia and to look at these things from a bottom-up perspective and to see the companies regularly.

Yuri Bender: Chris, you spend a lot of time selecting funds to invest in emerging markets, but looking through your latest selections for PWM readers, there are some quite small asset allocations in the portfolio to emerging markets. Within a €100,000 portfolio, there are two €1,500 allocations: one to Nevsky Emerging Markets Fund and one to the Threadneedle Asia Fund. Why are your allocations to emerging markets relatively small? What are the particular qualifications and philosophies of these managers that make them particularly attractive to your clients?

Chris Hills: Because we run a multi-asset-class model for our clients, the typical benchmark given to us by a private client would probably only have 3 per cent exposure to emerging market equities, which comes out of the Atkins benchmarks, against which most fund managers operate. Part of our job is to ask whether, strategically, we want to be overweight, and whether, tactically, now is the time to do that.

Many private clients are not financially literate, so they equate economic growth with share price performance. Over the last decade, they had a very painful experience from the volatility of equity markets, so they want less money exposed to equities than ever before.

They also say they invest in equities to access economic growth, so they ask where in the world they are going to achieve the maximum. That is where they all start. If you looked at the demand for Anthony Bolton's new Fidelity fund, much of it has come direct from private investors, because they equate China with rapid growth and Anthony is regarded as the top UK fund manager of the last thirty years and so they think it's a no-brainer to go for it. The institutional world has no followed that tactic, and neither have wealth-management houses. You might say China, yes, but not at today’s prices, and Mr Bolton may be a good manager but not necessarily the best person in China.

Also, if you are drawing an efficient frontier and looking at expected returns, and you can find a manager who operates well in an inefficient market and can outperform, does that not lend itself to having more weight in that than just investing in a tracker fund? We will certainly look at that. In the last few months, we have reduced our weight in emerging markets, but for very tactical reasons, because we think there is not enough evidence to reassure us that particularly China and, to some extent, India are going to be able to slow their economies as successfully as market prices probably assume.

While we know that managers cannot necessarily outperform in all circumstances, we know the circumstances in which we think they will outperform and we can put that into our melting pot. We are, then, renting fund managers for particular types of economic environment, rather than owning them throughout a cycle.

Yuri Bender: Lord Rothschild once said the time to invest is when there is blood on the streets. Unfortunately – and it saddens me to say so – there is blood on the streets today in Thailand and in Kyrgyzstan, and there are some tragic events taking place there. What are the implications of those events for developing economies?

Bill O’Neill: This comes under the umbrella of volatility and policy credibility, continuity and transparency. Ultimately, markets want to accurately assess and value the extent to which a risk premium on a market is on the rise or on the decline. A political risk premium is part of that. If you look at other markets around the world, Brazil is an example of one where, for a long time, the success in curing hyperinflation was distrusted, disavowed or underestimated. Mexico is an example where the government has gone a lot further in tackling the underlying economic issues.

These events have been with us throughout history. To the extent they are having an immediate impact on the policy decisions of a country – and Greece is an example in the developed bloc – the market is, as always, trying to focus on the extent to which this reduces or increases the risk premium on a sustainable basis. As we come out of the end of the great macro down-leg in the markets of 2008 and 2009, there is now much greater discrimination in terms of individual countries’ destinies and potential, and this is relevant to looking at emerging markets in terms of different asset sectors as well as simply within the equity-market pool itself. The big single-bloc macro call – in risk/out of risk – is passing away now. Stock and strategy selection are becoming more important. In some respects, we may see the return of thematic investment.

Marco Giubin: Thailand is the cheapest market in Asia. Considering what has happened there, some people may be surprised that it was down only 5 per cent today [after riots led to fatalities and serious injuries in Bangkok]. Thailand is one of the last countries in Asia that does not have its politics properly sorted out. Indonesia, for example, has made massive strides on the political front in the last five to 10 years, which is partly the reason why it was the best performing stock market in Asia in the last 18 months.

But these events make you look at Thailand even more closely, because it really does stand out within Asia in terms of valuation. Despite all the political difficulties that country has experienced in the last two or three years, it has continued to churn out decent economic numbers.

Yuri Bender: Is there sometimes an almost blinkered view among some banks, with a lot of importance attached to emerging market equities and not enough to equally attractive opportunities in the fixed income segment?

Alexandre Zimmermann: The emerging corporate bond market is a growing one. A few years ago, it was dominated by Latin American issuers and the default rate was quite high; there was not a lot of appetite from private clients for this segment. Things have changed in terms of the low level of yields they have on cash deposits or the very strong performance on investment-grade and high-yield markets in Europe and the US. Now, the investment-grade markets do not offer attractive enough yields. Some clients are going for equities in an attempt to capture the dividend yield and protect downside risk with derivatives; others are looking at investment-grade emerging corporate bonds.

This market is more diversified than previously. The level of outstanding debt is split 20 per cent in emerging Europe, 20 per cent Latin America and 30 per cent Asia, so one can find a decent level of diversification here in geographical terms. Around 80 per cent of outstanding debt is investment grade. Until a few months ago, one could find, in the same economic sector, issuers based in countries like South Korea with higher credit rating than European issuers, with the same currency and maturity but yielding 200 basis points more than European peers. There are some reasons for that, such as liquidity, political risk and volatile economic growth, but more clients are prepared to take this kind of risk and are expecting relevant solutions from their investment advisers.

The question is whether advisory clients will comfortably dedicate 20-25 per cent of portfolios to such investments. The best illustration is the European high-yield market, which offers higher yields with investment-grade issuers in countries like South Korea. South Korea is not Kazakhstan in terms of creditworthiness and the legal risk one runs when investing in those countries. This easily explains why there is more and more appetite for these investments.

Yuri Bender: Russia is one of the areas in which you analyse bonds. One of the particular attractions there is that there are many state backed bonds that have a predictable revenue stream. Are your clients generally aware of the political risk in Russia: that, like Khodorkovsky at Yukos, oligarchs can easily fall out with Vladimir Putin and their bond will become worthless?

Alexandre Zimmermann: Three or four years ago, we started to see demand for Russian-issued corporate paper from clients in that region, who were familiar with country risk. Now, it has expanded. A company like Gazprom is one of the major issuers in the credit market. Many domestic investors are familiar with this name but not with the risk associated with investing in such a company. The corporate bond market in Russia, at least in terms of Eurobonds, is dominated by oil or commodity-related companies and corporations whose bond issues are guaranteed by the government. That is quite attractive for clients because of the nature of the sector and the guarantee provided by some of these bonds.

However, the default rate in Eastern Europe increased dramatically over the past two years, and is much higher than other emerging regions like Latin America or Asia. The only region with a similar increase in defaults is the Middle East, especially Dubai. We have, then, to be very selective, but in terms of liquidity, Russia was probably the largest issuer last year, representing 50 per cent of new issues in 2009. Liquidity and appetite are there, but there is a lot of work to be done on credit analysis.

Yuri Bender: What will be the future of the Bric story and are there likely to be new entrants to the club, created by Bill’s near-namesake, Jim O’Neill?

Paul Marson: As someone who spent a long while at Goldman Sachs, I knew Jim O’Neill quite well. The underlying principle of his Bric hypothesis is fairly elementary to any economics student. It is a simple production function: you look for countries with large amounts of labour and capital, combine the two and you get rapid output growth. In an ideal world you get some multi factor productivity growth in the mix as well, so it all really takes off. The question in terms of the next stage of the Bric story is where are the areas of the world which have large amounts of labour and/or large amounts of capital. Indonesia is next on the map simply because of the large population.

There was a great book by William Bernstein, The Birth of Plenty, which looked at why some countries grow rich and others remain poor. Among other things, it talks about capital markets, development, scientific rationalism developing, property rights and transportation. If you bring all those together and seek out where the next opportunities might be, looking way, way down the road, Africa could be the next stage of the Bric story. You have huge amounts of labour; believe it or not you have enormous amounts of savings, so a very large pool of capital; bringing the two together in some way in a politically stable environment with a degree of property rights could be the trigger that fuels the next big evolutionary stage of the Bric hypothesis.

Marco Giubin: Indonesia has been an incredible success story over the last 18 months. Susilo Bambang Yudhoyono (SBY) got an overwhelming majority, so they can push through projects on much needed infrastructure spending. Their ability to keep inflation under wraps also meant they were able to reduce central bank rates from 13 per cent-plus to around 6.5 per cent. The appetite for government bonds has been phenomenal, with spreads in bonds contracting significantly.

Richard Carlyle: At Capital International, our approach is driven by fundamental, bottom-up research. We look across the suite of emerging market countries and pick the stocks we find most attractive. On that basis, Russia has already been demoted from the top four. If I look at the current portfolio, China is the biggest single area, second is Brazil; third is India, so three of the four Brics are in our top three but after that we have more money in South Korea, Taiwan, even in South Africa and Mexico than Russia. Indonesia is still smaller than Russia but has come up a lot recently. We will not demote Russia in our fund, but on that basis it is already out of the top four by a surprisingly long way.

Amin Rajan: I am very unhappy with the two titles: Bric and emerging markets. South Korea, with a better economic outlook and better governance structures than Japan, is not included in developed markets. Putting countries into these convenient buckets may be good for an idle chat, but I when it comes to serious investing, I would very much follow the pragmatic approach that Capital are adopting, that ‘Let us look at each of those situations on their own merit and not go for specific buckets or specific boxes.’

Jeremy Beckwith: There is a threat from the developed world because one of the major drivers of the emerging markets’ success has been globalisation and free trade, which has been a trend since the early 1980s. The breakdown of Doha marks the peak of that trend; the fear is that we reverse and go back to less free trade, more protectionism as the developed world seeks to protect its own economies because they have very high unemployment. You see this in discussions with the Chinese. Even now you are starting to see both the US and Europe looking harder at the fact that these emerging economies have huge trade surpluses with them. What will be worse is getting out of it. That is the danger: if that starts to unravel in the next three years, there could be a very nasty shock for both developed and emerging economies.