Time to overweight portfolios to emerging markets?

This month PortfolioConstruction Forum asked the research houses: Given the dichotomy between high growth emerging markets and low-growth developed markets, should all portfolios be ‘overweight’ to emerging market equities? If so, overweight to what?

Lonsec

Emerging markets are an acknowledged source of long-term investment growth. While currently 13 per cent of world equity market capitalisation, emerging markets are forecast to be the engine room of global growth for the foreseeable future, contributing over 40 per cent of global growth, according to the International Monetary Fund. 

However, it is important to recognise that strong economic growth alone is not sufficient to support strong equity market returns in emerging markets.

For example, Lonsec has analysed the relationship between gross domestic product (GDP) of the major BRIC economies (Brazil, Russia, India and China) and the annualised performance of each country‘s stock market on a rolling quarterly basis.

The results show that there are definitely many periods where positive GDP has been accompanied by positive market returns, but that has not always the case.

The results for China are particularly interesting. Despite annual GDP growth of 6 per cent or more between 1993 and 2010, there have been numerous periods when the stock market has declined dramatically, sometimes by 50 per cent per annum.

Therefore, strong economic growth in emerging markets may not necessarily translate into consistently positive returns on emerging market equity investments.

Nonetheless, Lonsec believes there remains a compelling case for including emerging markets within a diversified portfolio for growth-oriented investors.

We suggest that a 10-to-20 per cent allocation to emerging markets within the overall global equities allocation may be appropriate for clients with the appropriate risk orientation.

A 20 per cent allocation represents an overweight to emerging markets when compared to both the MSCI World index (0 per cent emerging markets exposure) and the MSCI All Countries index (circa 13 per cent).

However, when determining an appropriate level of exposure to emerging markets, it is important to remember that emerging markets should only be used within a portfolio as a return enhancer, not as a diversifier/risk reduction strategy.

That is, investing in emerging markets will increase the risk of the total portfolio, albeit with a commensurate increase in expected return.

Investors should also be mindful of the sources of indirect exposure to emerging markets within a portfolio.

Firstly, many global equities managers have scope to invest in emerging markets. Secondly, investors may already be exposed to emerging markets’ themes via their Australian equities allocation, in particular, resources.

China’s rapid urbanisation has fuelled demand for Australia‘s resources, with Australian mining stocks the clear beneficiaries.

The Australian equity market also shares characteristics with many of the larger economies in the MSCI Emerging Markets Index, which by their composition are also exposed to the fortunes of commodities (eg, Brazil, South Africa and Russia, which are 16 per cent, 8 per cent and 6 per cent of the MSCI Emerging Markets index respectively).

Therefore, any additional direct emerging markets allocation may result in an unintended doubling up of emerging markets exposure.

Mercer

It’s important to keep in mind that market capitalisation benchmarks are biased to past success and can become excessively concentrated.

The overseas equities sector is a wide investment universe, providing opportunities to build more efficient strategic allocations across the different sources of equity beta.

Mercer adjusts market capitalisation benchmarks by over-allocating to areas of the global equity universe that we expect to outperform over the longer term – both small caps and global emerging markets – but with a lower volatility equity component to offset the additional risk.

We believe that there is a strong structural story for increasing the weight to emerging market equities. Emerging market economies offer faster economic growth potential than developed markets.

Arguably, this growth differential has been exacerbated by the global financial crisis and the need for developed economies to delever.

While academic studies report a weak association between GDP growth and equity returns, Mercer expects relatively higher earnings growth in emerging markets and the prospect of higher returns. Of course, this will depend on the entry price.

Emerging market equities come at a cost of higher risk, and it’s fair to assume historic volatility of 25 per annum will continue. We seek to mitigate this higher risk elsewhere in the portfolio. 

The attraction of emerging markets isn’t restricted to beta. These markets are relatively inefficient and highly diverse, unlike developed markets where country indices tend to move in time with one another.

Potential for alpha is high, and emerging market managers have a strong track record of alpha generation. Mercer expects this alpha to exceed that achievable in developed markets.

As is always the case, some fine tuning may be required to get the balance right at total portfolio level. In constructing an overseas equity model portfolio, we advocate an overweight allocation to emerging market equities, relative to the MSCI All Country World Index.

An allocation of up to 20 per cent to emerging market equities within the total overseas equity allocation is appropriate in more growth-orientated, diversified model portfolios.

In more conservative diversified model portfolios, we recommend lower allocations to higher volatility, growth-oriented, strategies such as emerging market equities. 

In summary, an overweight position to emerging market equities offers the potential of higher returns from both a beta and alpha perspective, and a strategic overweight position relative to market cap weighted benchmarks is appropriate.

However, this comes with higher risk, which can be offset by incorporating a lower volatility equity component.

Morningstar

Emerging markets are no longer considered too risky or fraught with corruption, so a migration is underway as investment managers reach out for areas of growth and distance themselves from subsiding developed economies.

The reality is, though, that investors’ growth asset exposures are likely to already be significantly higher to this theme than would first appear.

What does overweight mean?

That depends on the benchmark to which you’re comparing. The MSCI World benchmark has no emerging markets exposure, so any holding in emerging markets versus that benchmark would constitute an overweight position.

A number of managers have moved to using the MSCI All Country World Index as their benchmark, which has an allocation to emerging nations of nearly 15 per cent. That’s the easy part to see. 

However, investors may already unknowingly have invested in emerging markets.

For instance, global equity managers own multi-national companies with profits increasingly sourced from up and coming regions.

For example, the Magellan Global Equity fund owns high quality companies listed in the developed world, such as YUM Brands (KFC/Pizza Hut), Colgate, and Unilever. According to Magellan’s analysis, in 2010 these three companies generated over 50 per cent of their total sales from emerging nations.

Accurately assessing the indirect exposure of a portfolio to emerging markets is not easy. In our 2011 Global Equity Sector Review, we note portfolio managers themselves find it very difficult to accurately assess a breakdown of earnings by country, as most companies don’t disclose this detail and instead often only make known revenue by region (eg Asia Pacific).

A global equity portfolio with indirect exposure to emerging market companies via a handful of stocks listed on emerging market exchanges, when combined with a dedicated emerging market manager, reveals a large emerging market footprint.

Morningstar believes most Australian investors are also more leveraged (and therefore overweight) to emerging markets than they may already realise.

Further to the above global equity example, the Australian equity market has a higher correlation to emerging markets than to global developed markets such as Europe and the US.

Most investors have a hefty allocation to large-cap Australian equities and through this, will be compounding their indirect emerging markets’ exposure.

This was shown by the abrupt sell-off of the Australian sharemarket in 2008, and then again in recent months. All of a sudden Australian investors have found themselves with an intrinsic play on emerging market growth without having to do anything differently.

Overall, Morningstar believes it is best to use dedicated emerging market strategies in moderation. We suggest blending that with a broader developed world allocation.

For instance, a typical growth investor with a 30 to 40 per cent allocated to international equities could incorporate an emerging markets investment as a subset of the broader global equities exposure.

And, while investors could select a dedicated emerging markets fund, they should first consider any potential indirect exposures they may have as a result of owning Australian and global equities. Many will find they are already well overweight.

Standard and Poor's

In addressing this question, we make the following assumptions.

Firstly, other equities in the growth asset component of a portfolio are used for comparison to assess emerging market (EM) equities performance.

Secondly, EM equities are listed shares in companies that derive the majority/significant proportion of their revenues from emerging market countries, irrespective of their domicile.

Emerging economies are growing faster than developed ones. But is this reflected in the performance of their respective equity markets?

Yes, it is. The MSCI Emerging Markets Net Return Index returned 8.06 per cent per annum for the 10 years to 31 August 2011, substantially outperforming the MSCI All Country World Index (ACWI) with a net return of -2.62 per cent per annum, and slightly ahead of the S&P/ASX 300 Accumulation Index with 7.23 per cent per annum.

Of course, in achieving this return, some constituent markets in the MSCI EM Index will have outperformed and others underperformed, highlighting both the risk and the opportunity of exposure to EM equities.

The relatively high correlation of the MSCI EM NR Index with the S&P/ASX 300 Accumulation Index (0.75 per cent over the period) raises the issue of just how much EM exposure an Australian investor has simply by owning a diversified portfolio of Australian equities.

Typically, the equity component of most Australian investors’ portfolios is at least 50 per cent weighted to Australian equities. Interestingly, while the total return experience has a high correlation, there are differentiated sources of return between markets – for example, industry sector exposures and dividend yields is approximately 4 per cent per annum for the S&P/ASX 300 versus 2.7 per cent per annum for the MSCI EM NR Index.

All things being equal, EM appears a more attractive long-term opportunity than developed world equities in the current environment.

However, despite this prima facie attractiveness, investing requires adequate compensation for risk assumed.

Historically, there is a range of political, regulatory, cultural, market and environmental risks in EM for which an investor should be compensated in order to support the case for investment and subsequent consideration of an overweight position.

So, for an Australian investors, what constitutes a benchmark weight to EM relative to global equities?

As at 30 June 2011, EM and constituted 1 per cent of the MSCI ACWI (projected to be 19 per cent by 2020), 28 per cent of global market capitalisation (projected to be 44 per cent by 2020) and 35 per cent of global GDP in US dollars (projected to be 49 per cent by 2020).

As an arbitrary level, adopting the global market capitalisation weight appears prudent. 

To conclude, it is rational to have a prudent and informed overweight allocation to the higher risk-adjusted returns available in EM equities.

However, in a portfolio construction context, there is a range of factors to consider before arriving at benchmark or greater exposure. These include the exposure that should be attributed to Australian equities, and which industry sectors, themes, geographies, and markets will provide the better risk-adjusted portfolio outcome.

Also, consideration should be given to the degree of EM exposure derived indirectly via companies listed in developed markets but which source significant revenues from the emerging markets.

Van Eyk

Most Australians may not realise just how much exposure they already have to emerging markets – through the local economy, by extension through exposure to the local stock market, the increasing share of revenue accruing to multi-nationals in the overseas portfolio, and the Australian dollar.

It’s even possible to mount an argument that the value of our houses is inextricably linked to the fortunes of emerging Asia. Australians will be very comfortable in a world where the importance of emerging and newly emerged countries continues.

On the other hand, Australia has the potential to trip badly if Asia (read China) stumbles. 

On that basis, it could be argued that Australians already have too much exposure to emerging markets – not because high growth, emerging markets and low growth, developed, debt-ridden markets have become synonymous with good and bad prospects.

This ignores the fact that ‘high growth’ in this case also involves high economic volatility, political instability and embryonic shareholder governance.

It also ignores the fact that markets are continually pricing in these factors. The recent divergence in growth and growth prospects means that emerging market companies now trade at similar valuations to developed country companies despite these factors. 

The real issue is therefore not whether we are witnessing the spectacular rise of many large emerging nations or whether they are likely to enjoy above average growth (all of which seems more likely than not).

Rather, the focus should be on how best to benefit from that trend from a portfolio perspective – taking into account expected returns (given current valuations) and potential political, economic and market risks (and not forgetting that it is perfectly possible for shareholders to largely miss out on the benefits of economic growth under certain unfavourable conditions).

Furthermore, there are deep-seated structural problems with running an emerging markets fund and this is probably what has led to the underperformance of most funds compared with index benchmarks.

For instance, an emerging markets analyst who is a national of a particular country (and arguably therefore brings a local’s knowledge) is likely to be biased in favour of their home country.

On the other hand, analysts that cover many different countries from the comfort of New York or London may find it tough to compete with the insights of locals.

It is also important to acknowledge that benchmarks can give rise to arbitrary exposures to certain markets.

An investor using benchmark-unaware overseas equity managers (or even those benchmarked to the MSCI All Countries Index) might view the question differently from one whose exposure is largely determined by the MSCI World Index given the latter lacks exposure to emerging markets and even some developed economies such as South Korea.

For all these reasons, van Eyk has long held a large and explicit strategic weighting to emerging markets.

However, at present, we are somewhat cautious and therefore underweight our strategic allocation to emerging markets, while using highly-rated managers that have the flexibility to invest in emerging markets when valuations warrant.

Zenith Investment Partners

There is no doubt that portfolios should have a significant and overweight exposure to emerging markets equities within the growth component of the portfolio.

However, it’s important to be sensible in how this is achieved as there are a number of considerations to be taken into account when achieving this overweight exposure. These considerations include:

• The Australian sharemarket has a high exposure to emerging markets growth via the heavy weight to resource- and commodity-based companies. Virtually all Australian portfolios are strongly overweight Australian equities;
• Many globally diverse companies (eg Coca Cola, Philip Morris, General Electric, Johnson & Johnson) generate large proportions of their overall revenue and profitability from their operations and/or sales in emerging markets; 
• Emerging markets equities are historically more volatile than developed market equities and therefore investors’ capital value can be more volatile;
• Emerging markets companies can be a lot less liquid than developed markets equities and therefore fund managers may not be able to sell smaller illiquid stocks in times of market crisis; and,
• Equity markets and equity market returns do not always directly reflect the fortunes of the underlying economies in which they operate. So, the fact that emerging markets economies are set to grow longer term will not automatically lead to constant positive returns for emerging markets equities. There will be times when emerging markets equities will be overvalued and therefore sensitive to corrections.

As such, Zenith believes the optimal way to achieve an overweight exposure to emerging markets equities is to:

• Include a quality, actively managed Australian equities large cap fund in the portfolio;
• Include a quality, actively managed global resources or commodities fund in the portfolio;
• Use truly active global equities managers whose portfolios do not reflect high weightings to developed markets and/or which invest in global companies with high exposures to emerging markets’ economies; and,
• Use a quality, active diversified emerging markets equity fund or regional fund (if you want to slant the portfolio to a particular emerging markets region) in the portfolio.

The weightings to each fund will vary depending by the portfolio type or investor risk profile but will achieve both an overweight exposure from a MSCI World Index weighting perspective, as well as a strong exposure to the underlying emerging markets economies.