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April 16, 2012
As published by State Street Global Advisors
Emerging markets can offer good risk/return potential, attractive valuations, vigorous fundamental growth, significant diversification benefits, and a broad range of opportunities not often available to investors in developed markets. While investing in emerging economies does involve some unique risks, they may potentially offer suitable investors a long-term investment horizon to capture added-value and improve the performance of their traditional portfolios.
Emerging Markets Developing, But Not Small:
The terms "emerging markets" and "developing countries" are sometimes used interchangeably. Generally defined, emerging markets are countries that are experiencing rapid economic growth and financial and economic liberalization, prompted by policy reforms. Typically, they have immature capital markets and only partially developed institutions. Frequently, these countries are undergoing rapid economic, political and social transformation.
Generally, the per capita incomes and Gross National Income (GNI) of emerging markets are just a fraction of those of developed world economies. The World Bank classifies countries into four income categories. A majority of emerging countries fall within the bottom three categories and have a GNI per capita income of below $12,276.00. By comparison, the United States 2010 GNI per capita was approximately $47,390.00.1
A few countries, Korea, Czech Republic, Hungary and Poland for example, fall within the high income category; but from an investor's perspective, they may be considered to be "emerging" due to specific structural and political issues.
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Emerging markets are not all small countries. China and India, for example, are the two most populous nations in the world; and their inexpensive—and increasingly skilled—labor makes them attractive areas for direct investment. Their tremendous human capital has been a hot bed for labor-intensive as well as technological outsourcing over the past several years. Brazil and Russia, two additional emerging countries, are resource-rich locales benefiting from the world's escalating need for energy and natural resources.
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Despite the physical size and large populations of emerging countries, their equity markets have historically been underdeveloped. To illustrate this point, the combined population of all emerging markets, as defined by the International Monetary Fund, totals more than 3.9 billion people—that's roughly 57.0% of the world's entire population.2 In contrast, the total market capitalization of the equity markets for these emerging countries represents only 12.46% of the world's total equity markets.3 There are some complex issues behind this simple comparison. However, assuming underlying conditions remain favorable over the long-term, emerging equity markets clearly have room to grow and increase their share of the global opportunity set.
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Why Emerging Markets?:
Now that we understand what constitutes an emerging market, why should investors consider allocating a portion of their portfolios to emerging markets?
Growth Of Emerging Countries:
According to the International Monetary Fund (IMF), emerging countries are likely to continue to grow more rapidly than the developed world in the decades ahead. Many emerging markets countries have a stronger Gross Domestic Product (GDP) growth outlook relative to developed markets.4
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Also, burgeoning population growth, the emergence of younger and more educated workforces, and increasing infrastructure demands should provide a favorable environment for the asset class. In addition to the growth fueled by domestic demand, the better-run emerging markets' companies may continue to expand their activities in developed markets. Names such as Samsung Electronics, Gazprom and Taiwan Semiconductor are examples of companies located within developing markets that have world class products, first-rate management and potential competitive advantages derived from either natural resources or human capital. As trade barriers fall (e.g., WTO entry, accession to the EU), these better quality emerging markets companies may see expanded growth opportunities.
Long-Term Return Potential:
Emerging markets possess the potential to exceed developed market returns over the long term. Rapid economic growth tends to translate into stronger company earnings growth and, thus, higher stock prices.
In fact, Figure 5 below shows us that for the ten years ending December 31, 2011, the MSCI Emerging Markets (EM) Index posted a 13.86% return, versus a 4.67% return for international developed markets (MSCI EAFE Index) and a 2.92% return for U.S. Markets (S&P 500® Index). However, emerging markets are also considered riskier than developed markets, with increased potential for losses.
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Diversification Benefits:
Emerging markets, generally, have not moved in tandem with those of the developed world in the recent past. As a result, for suitable investors, emerging markets may be used as a diversification and risk management tool to augment traditional portfolios.5
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The correlation coefficient measures the degree to which the movements of two variables are related. For example, a correlation of 1.00 (or 100.00%) would indicate that the two asset classes monthly returns move in the same direction (positive or negative) for the stated time period.
In contrast, a correlation coefficient of -1.00 would mean that the two indices move in opposite direction. A correlation of zero indicates that the two exhibit no discernible relationship.
The potential diversification benefits emerging markets provide may increase even further as emerging markets develop sector mixes that are very different from those of developed markets. As illustrated in Figure 7, there are significant differences in sector weights between emerging countries and the developed world in the construction of the respective indexes. Emerging markets tend to be more focused in the basic materials, energy and telecommunication sectors. Alternatively, the developed markets, as represented by the S&P 500 Index and MSCI EAFE Index, typically have larger weights to the Consumer Staples, Health Care and Industrials sectors.6 Remember that diversification does not ensure a profit or guarantee against loss.
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Volatility As Opportunity:
Despite the strong returns in recent years, emerging market equities remain a volatile investment choice. Some investors may recall the sharp declines of 1998 or even the 53.0% drop in 2008. However, investors who can tolerate the additional volatility may potentially be rewarded with higher returns over time. The higher potential for extreme market events may translate into greater opportunity for suitable investors, but also present greater risk of loss. Such events in developing countries can often be mechanisms of positive fundamental change, creating compelling investment opportunities that are difficult to uncover in the developed world.
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A Word About Risks:
As already alluded to, EMs do present unique risks. Like all asset classes, they carry market risk. However, they are also predisposed to three risk elements which do not raise concerns for traditional domestic investors.
- A lack of information standards within the country and/or region.
- The risk that the currency of the stock exchange where the investment is located may depreciate against the U.S. Dollar.
- Political risk long considered by many to be the dark side of emerging markets may prove cumbersome because the impact of political events on investments is extremely difficult to measure.
These risks are reflected in the higher volatility in EMs, as well as the increased risk of loss.
Conclusion:
Despite the unique risks associated with investing in emerging markets, which can be substantial, investors who have never considered investing in the asset class—or who previously have only opportunistically invested—should take a closer look and earnestly consider the asset class' potential advantages in helping investors to achieve their strategic asset allocation objectives. Although emerging markets present higher risk than developed markets, they potentially offer suitable long-term investors attractive potential to capture excess return and diversify traditional, developed market portfolios, ultimately increasing portfolio efficiency and improving overall performance.
Index Definitions:
Barclays Capital U.S. Aggregate Index:
The Barclays Capital U.S. Aggregate Index represents the securities of the U.S. Dollar-denominated, investment grade bond market. The Index provides a measure of the performance of the U.S. Dollar-denominated, investment grade, bond market, which includes investment grade (must be Baa3/BBB- or higher using the middle rating of Moody's Investor Service, Inc., Standard & Poor's, and Fitch Rating) government bonds, investment grade corporate bonds, mortgage pass through securities, commercial mortgage backed securities and asset backed securities that are publicly offered for sale in the United States.
Gold London PM Fixing:
The London fix is a method of determining the price of gold. It is carried out twice a day (10:30 A.M. and 3:00 P.M., London time) by the five members via a dedicated conference call facility.
MSCI EAFE Index:
The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. As of May 30, 2011, the MSCI EAFE Index consisted of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
MSCI Emerging Markets (EM) Index:
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. As of May 30, 2011, the MSCI Emerging Markets Index consisted of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
S&P 500® Index:
The S&P 500 Index is composed of five hundred (500) selected stocks, all of which are listed on the Exchange, the NYSE or NASDAQ®, and spans over 24 separate industry groups.
S&P SmallCap 600® Index:
The S&P SmallCap 600 Index measures the performance of the small-capitalization sector in the U.S. equity market. The selection universe for the Index includes all U.S. common equities listed on the NYSE, NASDAQ Global Select Market, NASDAQ Select Market and NASDAQ Capital Market with market capitalizations between $250 million and $1.2 billion. The Index is float-adjusted and market capitalization weighted.
Footnotes:
1 WorldBank.org.
2 IMF.org, World Economic Outlook Database, September 2011.
3 MSCI, FactSet as of 12/31/2011.
4 IMF.org.
5 Diversification does not protect against loss.
6 S&P, MSCI, FactSet, as of 12/31/2011.
Source: This article was excerpted from "A Case For Emerging Markets", SPDR University, www.spdrs.com.
COPYRIGHT 2012 STATE STREET CORPORATION
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