Emerging Markets Revisited

Here's a short piece I wrote for a financial executives professional group on emerging markets.  Since I did quite a bit of research beyond this, you'll see more on this topic in the coming weeks.  Incidentally, there has been a problem with hijackers taking control of the referring website function for this blog. It has been reported to Google, so we'll see where this goes.  

Emerging market equities (“EME”) belong in an investor’s broadly diversified portfolio because they offer higher prospective returns albeit with higher expected volatility. Going forward, we believe that a selective approach to ownership, meaning active management, may be superior to one hewing closely to a broad, EM index. 

The economic case for EME centers on several themes: higher GDP growth rates; younger populations; increasing investment and efficiencies from infrastructure development; maturing financial services companies; export growth, and growing middle class discretionary spending. Ruchir Sharma, Head of EM at Morgan Stanley, makes this case well in a readable book.

In order to translate these into growth in corporate earnings and portfolio returns, investors need: political stability, strong respect for property rights, effective dispute resolution, a predictable regulatory and tax regime, a positive foreign investment climate, efficient markets, strong corporate governance, reliable corporate auditing and financial reporting, ethical managements, transparent corporate structures, and economies balanced between exports and internal consumption. Divining the strengths and weaknesses of an EM in these areas can only be done by active management, with experience in the markets, boots on the ground and a disciplined investment process. 

From 2000-2010, the annualized return on the MSCI Emerging Markets Index was 10.9% vs. 1.3% for the MSCI World Index of developed markets.  Since then, performance across the MSCI index universe of 21 EM and 24 frontier markets has been uneven and disappointing, with volatilities up to 50% higher than developed markets, and high correlations.  In recent times, it has mattered greatly what an investor owned and didn’t own. 

What went wrong?  What can investors do moving forward with their EME sleeves of their portfolio?

Some EM countries like Brazil and Russia are heavily tied to commodity exports, from oil and gas to soybeans and minerals.  In the case of Russia, demographics aren’t favorable, and political issues don’t point to stability going forward.  China’s planners are working hard to swing their export juggernaut more towards producing for domestic consumption. This requires more access for multinationals, but they are coming under scrutiny for breaking price regulations, which serve as a form of non-tariff barrier to growth. 

A CFA Institute paper suggests that historical exposure to India and South Africa, while excluding Russia and Brazilian holdings, can generate incremental portfolio return and perhaps reduce overall portfolio risk.  Selectivity in EM portfolio structuring seems to be better for portfolio risk management.

Indian equities, according to Morgan Stanley, are up 33% YTD (7/31) compared to the diversified EM index up only 8%.  This market offers rising middle class consumption, a growing financial services sector and a relatively balanced economy, among other attributes.  On traditional portfolio metrics, EM markets are not cheap, but investors must make their decisions on a longer-term horizon in order to reap their expected returns.  Morgan Stanley’s Lisa Shalett writes that Mexico offers similarly attractive features in the current environment.  Taking a long view, a selective EM portfolio, with the right countries and some more small and midcap exposure, will probably yield superior returns to broad indexing.