Boom or bust?

The rebranding of the lower income countries from ‘third world’ to ‘emerging markets’ represents not only a change in perceptions, but has also come to reflect a real change in the global economic structure.

“The increasing integration of more than two billion people in former command/socialist economies will continue to shape the structure of world output and savings and investment for many years to come,” says George Hoguet of State Street Global Advisors (SSGA).

Moreover, the ‘BRIC’ hypothesis put forward originally by Goldman Sachs, that the share of world GDP represented by Brazil, Russia, India and China is set to rise significantly, has been validated over the past five years.

“The BRICs represent both a supply and demand shock to the global economy,” continues Hoguet. “Rapid growth in the BRICs has increased world actual and potential GDP and the supply of loanable funds, and helped to reduce inflation, inflation volatility and inflation risk premia.”

Many would agree with Hoguet’s conclusion that, “at a minimum, investors should consider holding emerging market equities as a strategic asset allocation at a float-adjusted world market weighting, now about 8% of the MSCI ACWI IndexSM”, while some would advocate even higher weights reflecting the transference of savings from ageing populations in the developed world, to the higher growth potential evident in many emerging markets with much younger populations.

Being substantially overweight emerging markets has contributed heavily to the outperformance of the most successful global equity funds of the last few years and, in many cases, may have represented the largest real bet taken. However, Hoguet also points out that growth in output does not necessarily lead to superior investment returns, while the huge rises seen in the last few years in markets such as India and China, which many would argue is now reaching “bubble” levels, does raise questions as to whether this is the right time to be increasing exposures and if so, to which markets.

Moreover, some would question whether all the real risks are being taken into account. Dimensional Fund Advisors (DFA) in the past completely excluded Russia and China from its merging market funds and has only just decided to include China this year. Its London-based CEO, Philip Nash, admits: “We have never been comfortable with Russia as a market. We feel there is too much political interference. Generally, the feeling is that Russia is not sufficiently open and committed to free markets.”

He continues: “Our investment committee went to China recently and felt that the regulators had tightened up, and had a commitment to freeing the market. Non-strategic sectors are more open and deregulated. We felt those parts of the market should be as exposed to market forces as any other emerging market.”

One problem with assessing risks as Hoguet says is that unlike US large cap stocks, there is no long time series on which to base assumptions of the long-term equity risk premium: “Contrary to capital market theory, dollar denominated emerging market debt - for the longest time series we have (since 1995) - has substantially outperformed emerging market equity. Of course, these data are time-period-dependent, but they reinforce the observation that we are dealing with a short time series.”

What is evident is that not only are time series data for emerging market equities too short to adequately assess long term risk premiums but as Robeco’s head of emerging markets Wim-Hein Pals says: “We are in the middle of a long-anticipated re-rating of the emerging markets equities. In the aftermath of the Asian crisis, share prices reached a ridiculously low level and price/earnings multiples in some countries such as Brazil were in the low single digits - four to five times earnings were not an exception in those days. Over the last three to four years we have gone to low double digit price/earnings multiples for the asset class as a whole. But emerging markets are still trading at a significant discount to the developed equity markets on average.

“The discount of some 20% is unjustifiable given the strong macro

2007and micro environment we are in. Not only does the highest economic growth come from the emerging economies, but also the highest earnings growth will come from emerging companies.” Pals continues: “On average for 2007 we expect 17% earnings growth in emerging markets versus 8% for developed markets. In terms of valuation comparison, emerging markets trade at 12 times expected 2008 earnings whereas developed markets are trading at 15 times.”

“Valuations are still reasonable, so emerging equity markets are not too inflated. And therefore I foresee a continuation of the re-rating process until the very moment emerging markets trade at a premium to developed markets.”

This view does raise the question as to the equilibrium price/earnings ratio relationship between emerging markets and developed. Other commentators such as SSGA’s Hoguet are more cautious than Pals. “There are risks in emerging markets so they should sell at a discount, but increasingly a smaller one,” he argues.

Perhaps the most profound characteristic of emerging markets as an asset class, is that it is increasingly becoming ludicrous to lump together the 30 or so very different countries in the MSCI index and hope to get any common characteristics, beyond perhaps the fact that stocks still tend to have a far higher correlation with their local country index than the global sector index.

Not only is there a vast geographic spread, but also the two largest countries in the MSCI index, Korea and Taiwan, which between them account for 25%, are better described as emerged rather than emerging markets.

Index concentration is also very high and adding in the next three largest countries, China, Brazil and Russia represents around 60% of the index. “Traditional long-only global emerging markets mandate, which have tended to track established emerging markets indices, have produced portfolios heavily weighted to the seven largest countries in the index” says Kemal Ahmed, the founding partner and CIO of Old Square Capital Advisors. Moving away from too rigid a focus on indices can lead to a more open look at possible opportunities. Russell Investment Group’s Scott Crawshaw sees that emerging market themes that are attracting interest include small cap products, frontier market products and less benchmark-sensitive products.

Old Square’s portfolio for example, is benchmark agnostic and is the product of fundamental, bottom-up, manager analysis, “focused on the best in-country and regional stock pickers that the firm can find with a skill set that includes the more difficult frontier markets such as Botswana and Bangladesh”, according to Ahmed.

But there can also be dangers in some of the enthusiasm that has been generated for emerging markets. While the BRIC concept, for example, presents some interesting analogies between four very different but potentially very large economies in the longer term, it has also been taken as a marketing concept to launch funds that have little fundamental rationale as short term investment plays. What is clear is that, as Crawshaw points out, “improved market fundamentals are allowing managers and investors to take a longer term perspective of markets”, which amongst other things, “has led to a flood of private equity investment into the asset class”. Given the fact that emerging market stock markets represent a much smaller fraction of GDP than in the developed markets, this is probably no bad thing, provided the investment expertise can be found.

When it comes to developing an investment process for emerging markets, the key decision has to be whether the country allocation or the stock selection should take precedence.

Pals of Robeco, a top down manager, argues: “It is so much more important that you pick the right country: a strong company in a lousy performing country will most likely underperform a mediocre company in a strong country.”

Ashmore takes this process to an extreme being essentially an emerging market debt specialist, it runs emerging market equity portfolios by taking only country bets purchasing the most liquid stocks in markets it wants exposure to focused on total return.

Ashmore’s Jerome Booth says that its process will complement a more traditional bottom-up approach. “We see most demand from larger investors who employ more than one EME manager,” he says. DFA in contrast, takes no active country views at all, apart from the total exclusion of countries that are deemed to be unacceptable, such as Russia.

While its approach is passive, rather than using an index, which would lead to artificially induced turnover and rebalancing costs, DFA runs value, small cap, core and large cap portfolios based on establishing low turnover and purchasing everything defined within the category so that the value portfolio based on a simple purchase of the top 30% by book to market has around 1,500 stocks, according to Garrett Quigley, senior portfolio manager at DFA.

It is at the individual stock level in emerging markets, where there may be less information available, but a huge opportunity set, that the real potential for emerging market equity investment may lie. This opens up the potential for substantial outperformance from those managers who are truly able to search deep within any individual country’s stock markets. Old Square’s Ahmed argues: “It is in these less than transparent markets that in-country managers and regional specialists have an information advantage.”

As well as the more traditional qualitative analysis, as Russell’s Crawshaw argues, “the increased quality and availability of data in the asset class has seen an increased use of quantitative methods in general. The coverage, consistency and distinctiveness of these approaches help to offset the limitations of dirty data and short data history.”

This has led to the launch of products by pure quantitative managers such as Axa Rosenberg. Given the potential for obtaining alpha, it is not surprising that Crawshaw is also seeing “a trend towards more concentrated portfolios and less benchmark sensitivity” with interest also in unconstrained investment.

With the immense difficulties of researching such a large and disparate universe, with Russell’s Crawshaw finding that some of its favoured global emerging market managers actively follow a universe of more than 6,000 stocks, does this favour single country or regional specialists over global generalists? Russell has a preference for a multi-manager approach using global managers, with Crawshaw arguing that global managers have increased flexibility to emphasise the best investment ideas on a truly global basis in their portfolios.

“This flexibility also allows them to avoid unattractive countries and regions as well as finding the best opportunities in frontier markets that have not graduated to the full index. From a multi-manager perspective we believe global managers provide an additional level of diversification given the breadth of investment approaches used in the asset class compared to regional managers,” Crawshaw continues.

While demand for emerging market equities is predominantly for global funds, this creates both the problem that many good global emerging market managers have now closed to new investment, and also that there are many good regional and country managers who

2007are unable to generate much interest because of their limited geographic exposure. Indeed, Nomura Asset Management commissioned research by Mercer Oliver Wyman which indicated that a combination of the best regional managers into a single product “consistently outperformed the top quartile average of the single Global Emerging Market managers”. It also said that “a combination of the average regional manager into an aggregate EM product” outperformed single global emerging market managers.

Nomura has a well-established Asian emerging market equities team, managed from Singapore, but lacks exposure to Latin America and the Europe-Middle East Africa (EMEA) regions.

In response to the overwhelming demand for global rather than regional managers Nomura’s Mark Roxburgh explains: “We undertook a publicly tendered search in IPE-Quest for Latin American and EMEA managers and in the end chose Gartmore for Latin America and Charlemagne for EMEA”.

This regional specialist product with Nomura as lead manager, Roxburgh adds, “has found appeal among mid-sized and smaller pension funds, who want specialist exposure but are too small to be able to justify the costs of going down that route themselves. They acknowledge that a combination of Nomura, Charlemagne and Gartmore, all with strong regional credentials, provides a convincing alternative for management of emerging market equities.”

The multi-manager specialist route has been taken one stage further by Old Square Capital Advisors. CIO Kemal Ahmed has capitalised on his IFC experience to establish and in certain cases seedcorn a portfolio of very high alpha country and regional managers.

He found that smaller, resource constrained, institutional investors seeking emerging and frontier markets exposure are limited in their ability to undertake meaningful due diligence on specialist strategies and smaller countries. With initial funding by a university endowment and a multi-family office, Old Square invests mainly with in-country long-only equity and fixed income managers in both more developed and frontier emerging markets as well as equity and fixed income hedge funds with emerging market expertise, according to Ahmed.

The Chinese economy is now larger than the UK’s and by 2010 at current growth rates, it will be larger than Germany’s and by 2040 larger than the US. The question for emerging markets is whether the process of globalisation of trade between countries will grow indefinitely without a setback caused by an economic or political crisis. The dilemma for institutional investors as to what route should be taken to invest in emerging market equities, can also turn attention away from other alternative emerging market asset classes such as emerging market debt, infrastructure, private equity and property, all of which may offer superior investment opportunities to the listed equity markets.

Focus Capital, set up last year by John Cleary, has adopted the viewpoint that it is better to be able to switch dynamically between all emerging market asset classes, although his fund is currently 100% in equities.

“In the early part of the cycle, debt outperforms, in the late part, equities outperform and in the middle, a mixture of cash and alternatives,” says Cleary.

“Hedge funds have failed to beat long only managers and even if they matched returns, the fees eat into the return, while they have also underperformed on the downside.”

As Russell’s Crawshaw points out: “Increasingly one important division in the asset class is managers who are open to new assets and those that are closed to new business; given the strong demand for the asset class many managers have had to calculate the appropriate capacity for their emerging market strategies and many have taken the decision to close.

“To compensate for this we have seen a number of new product offerings come to the market and a number of EM boutiques opening.”

Given that many of these will be single country or regional managers, new investors or those looking to substantially increase their weights, should look seriously at the multi-managers able to combine single country and regional managers to give the desired long-term exposure to an asset class that can only grow in importance.