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CIO REPORTS

The Monthly LetterThe Chief Investment Officer Team • JULY 2013

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Emerging Markets—Time for a CHANGEEver since the creation of the BRIC (Brazil, Russia, India, and China) acronym, investors have been aware of the opportunities inherent in investing in Emerging Markets (EM). However, the meteoric performance of BRIC markets between 1999 and 2007 (see Exhibit 1) and the subsequent realization that many EM have already “emerged” now has investors looking for new go-to buzzwords to invest in. We believe the most important buzzword investors should take into account when considering the next phase of EM investment is CHANGE.

In this CIO Monthly Letter, we discuss the fundamental change in many EM from a decade ago and explain why this

reduces the likelihood of a repeat of the 500 percentage

point outperformance of EM relative to the developed world

seen from 2000 to 2007. We explain our preference for

allocating to smaller EM (as well as frontier markets) within

portfolios. We discuss our economic and market views for

the four BRIC countries and explore where opportunities

lie within the BRICs. Last, we show how the investment vehicles have also changed, demonstrating how passively

allocating to broad Emerging Market vehicles now over-

allocates to large, in our view worse-performing economies

and under-allocates to smaller, better-performing and under-

owned ones, and why actively managed funds represent a

more effective strategy going forward.

Our bottom line is that investors should consider an allocation to smaller emerging and frontier markets as these countries have better return prospects when compared to BRIC or larger EM, in our view. Implementation-wise, we believe investors should focus on non-benchmark constrained, flexible active managers that have an allocation to smaller EM and frontier markets as part of their exposure to EM growth.

How EM has CHANGED over the last decadeIn response to ongoing demographic pressures, many large

emerging economies, especially China, are undertaking

an economic transformation, shifting from exports and

infrastructure to consumption as the principal driver of

growth. We believed investors would generally tolerate

such a change. Following two years of underperformance

by EM from 2011 to 2012, we were becoming more

optimistic about the prospect of a rebound in Chinese and

EM equities toward the end of the first quarter this year,

advising investors to re-focus on opportunities that we

expected to develop around the middle of 2013. Instead,

as Chinese and EM economic data further disappointed,

monetary and fiscal policy remained tighter than

BRIC Markets Developed Markets

0

100

200

300

400

500

600

700

800

1999 2000 2001 2002 2003 2004 2005 2006 2007

Exhibit 1: BRIC markets significantly outperformed between 1999-2007...

Source: Bloomberg, IMG

CIO REPORTS • The Monthly Letter 2

anticipated, political risks rose and profit margins fell, EM (and in

particular Chinese) equities have performed far worse than we had

hoped (see Exhibit 2).

The change in the fundamental growth outlook and collapse in

profit margins has pushed us to revisit the medium-term outlook

for EM, which has been downgraded in recent quarters, reflecting

weaker domestic conditions and tighter financial conditions

following the rise in U.S. interest rates (see Exhibit 3). Questions

are being raised as to how much of this slowdown is cyclical or

structural in nature. We believe that it is a combination of both

cyclical (e.g., lower exports and tighter monetary policy) and

structural factors (e.g., lower productivity growth and less favorable

demographics). Even as cyclical factors begin to improve into 2014,

such as a pick-up in global trade, the growth rates of many larger

emerging economies will be lower due to the structural changes

underway. Overall, the potential growth rates in many of the larger

EM are on a downward trend (see Exhibit 4) from their heights, and

we don’t see this trend reversing anytime soon.

As a result, we do not believe there will be a repeat of the 2000-

2007 outperformance in the coming years. Essentially, this

outperformance was a combination of a rising share of global

gross domestic product (GDP), high corporate profitability and

improving corporate balance sheets, extremely favorable starting

valuations, and improving fundamentals throughout the emerging

block. Some of these fundamentals included reduced external

debt, rising foreign reserves, a build-up of current account

surpluses (see Exhibit 5), and declining and negative real interest

rates (largely driven by falling real interest rates in the U.S., see

Exhibit 6 on the next page).

BRIC Markets Developed Markets China

75

80

85

90

95

100

105

110

Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13

Exhibit 2: ...but have been disappointing year to date

Source: Bloomberg, IMG. Data as of July 2013

Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

Exhibit 3: Financial conditions in EM have tightened

Source: BofA Merrill Lynch Global Research, IMG. Data as of July 2013.

2003200119991997 2005 2007 2009 2011 2013

KoreaChina

South AfricaIndiaMexico

PolandGEM-10Turkey

IndonesiaBrazilRussia

-5-3-113579

111315

Exhibit 4: Potential growth rates for big EM have peaked

Source: BofA ML Global Research, IMG

Current Account Balance (% of GDP) External Debt (% of GDP, Right)

20

25

30

35

40

45

-4 -3 -2 -1 0 1 2 3 4 5 6

1999 2002 2005 2008 2011

Exhibit 5: EM external debt and current account positions improved in early 2000s

Source: IMF, IMG. Data as of end 2012.


EM companies benefited during the boom as well. Profit margins

grew, corporate leverage was declining, and return on equity (ROE)

was rising (see Exhibit 7). With EM equities trading on attractive

absolute and relative valuations to the developed world in 2000,

the improvement in economic and corporate fundamentals drove a

relative re-rating of the EM bloc (see Exhibit 8).

The structural advantages noted above have to a large degree

been exhausted by emerging economies. As can be seen in Exhibit

9, GDP growth rates are lower post-crisis, and fiscal positions have

begun to reverse. As Exhibit 5 on the previous page shows, current

account surpluses are now declining, too.

Furthermore, as U.S. real Treasury yields begin to rise as the

U.S. Federal Reserve (Fed) unwinds its unconventional monetary

policies and eventually raises interest rates, EM real interest rates

are likely to follow. On the corporate side, profitability and ROE

has been on a declining trend since the financial crisis as excess

capital has flowed to less productive investments.

With some of the previous supports turning into potential

headwinds, doomsayers argue that the disappointing returns from

EM assets over the past two years are set to continue. We see

merit in some of the arguments made. However, not all of the tail

winds will turn into headwinds. For example, lower credit creation

and higher real interest rates should allow for higher future ROE

as unprofitable companies go bust. External debt positions and

reserves should continue to remain strong, which should mitigate

the likelihood of a balance of payments crisis in turn potentially

reducing the volatility of emerging economies’ foreign exchange

(FX) rates.

Emerging Markets U.S.

-1

0

1

2

3

4

5

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Exhibit 6: Declining real interest rates spurred economic growth

Source: BofA ML Global Research, IMG. Data as of July 2013.

EM Margins EM Return on Equity EM Leverage

35%

40%

45%

50%

55%

60%

65%

70%

75%

4

6

8

10

12

14

16

18

20

2000 2002 2004 2006 2008

Exhibit 7: EM corporate fundamentals improved between 2000-2007

Source: Datastream, BofA ML Global Research, IMG

Emerging Markets Developed Markets EM relative to DM (Right)

0.4

0.5

0.6

0.7

0.8

0.9

1.0

5

7

9

11

13

15

17

19

21

23

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Exhibit 8: EM benefited from starting low absolute and relative valuations (12m forward PE)

Source: Factset, IMG. Data as of June 2013.

Change in Debt/GDP ratio

GDP

Grow

th R

ate

%

0

2

4

6

8

10

-20 -15 -10 -5 0 5 10

2009-20121999-2008

Lower GDP

Worse debt/GDP

EM

Asia

CEE* Latam^

Exhibit 9: Post financial crisis, EM growth rates have declined and debt-to-GDP worsened

Source: IMF, IMG. *CEE = Central and Eastern Europe; ^Latam=Latin America


Therefore, we think that writing off the entire emerging bloc disregards many opportunities that still exist. As we have highlighted in our “A Transforming World” communications, the growth of EM, especially the middle class, is one of the largest economic shifts ever experienced. EM already account for more than half of GDP growth and 40% of investment worldwide. Ignoring EM means missing considerable investment opportunities in the world, and in many cases there is still plenty of upside.

Instead of aggregating the bloc as a single investment, focusing individually on country- or sector-specific trends within EM will, in our opinion, provide better returns over the coming years. In our opinion, the days of significant broad re-rating of EM relative to the developed world are behind us as the structural drivers of this re-rating fade, but plenty days of still-healthy returns lie ahead. This will, however, require investors to be more selective and flexible, to not limit investment opportunities to outdated benchmarks, and to focus less on large BRIC markets and more on smaller emerging and frontier markets.

A CHANGE beyond BRICs from an investment perspectiveThe term Emerging Markets covers a broad set of developing countries. Of these, the most

economically and capital-advanced have been classified together to capture the performance of

the whole. (Currently, 21 countries led by the BRICs, Korea and Taiwan are classified as emerging

within the MSCI Emerging Markets Index.) Most Emerging Market fund managers invest within

this grouping of countries. Frontier markets are a subset of smaller emerging economies with less

developed capital markets. These countries are typically not included in EM index funds and are often

not invested in by broad benchmark constrained Emerging Market active managers (see Appendix on

page 12 for country classification between EM and frontier markets).

However, we think many of these smaller emerging and frontier countries represent some of today’s best investment opportunities within the developing world. Many of these economies have high prospective growth rates, large current account and fiscal surpluses and lower public debt than their larger cousins. They trade on undemanding valuations and have improving and deepening capital markets. In many ways, you might say they are in a similar position as EM countries were around 2000.

As Exhibit 10 shows, over the next five years non-BRIC EM are

forecast by the International Monetary Fund (IMF) to grow at the

same rate as their pre-crisis levels while BRIC growth is expected

to go lower than the pre-crisis trend. Additionally, many smaller

emerging economies are under-owned by investors, have relatively

stronger domestic economies, are less vulnerable to foreign

capital outflows, and may also have greater monetary policy

flexibility.

For example, Indonesia and Peru have both seen their average

growth rates since the financial crisis remain above pre-crisis

levels, at the same time their government-debt-to-GDP ratio has

declined. For Indonesia, removing expensive subsidies could free

up public funds to further support growth. Growth in Chile and the Philippines has not been any lower

post-financial crisis and the IMF forecasts both these countries to grow at roughly 5% per year over

BRIC Non-BRIC EM 0

1

2

3

4

5

6

7

8

2000-2008 2009-Present 2013-2018

Exhibit 10: Non-BRIC EM to return to pre-crisis growth rates, unlike BRIC

Source: IMF, IMG. Data as of April 2013.


the next five years at the same time their fiscal positions are forecast to improve. A similar story

exists for Colombia. Malaysia has increased investment as a percentage of GDP, which should lead to

an even higher growth rate. Meanwhile, our colleagues in Bank of America Merrill Lynch (BofA ML)

Global Research have highlighted Mexico and Turkey for their potential to become significantly bigger

contributors to global growth. Mexico is also highly integrated into the U.S. economic cycle (mainly

through labor income repatriation and trade), so it should benefit from the ongoing recovery in the U.S.

Better profit opportunities can also be found in non-BRIC economies. Indonesia, the Philippines and

Thailand all have higher ROE than China, although there have been significant fund flows into these

regions, which have caused some re-rating. Many of these regions continue to have strong domestic

consumption stories, selected countries are less vulnerable to foreign capital outflows, and many haven’t

experienced anything like the domestic credit surge seen in China. Mexico, too, has a ROE above 15% and

a low representation in the MSCI EM Index that makes significant fund outflows less likely.

One of our Top 10 Portfolio Actions for 2013 is focused on

frontier markets, the even less-developed economies that

encompass such countries as Qatar, Kuwait and Nigeria. The

universe of frontier markets, as measured by the MSCI Frontier

Emerging Markets Index, is small—less than twice the size of

Apple. This has often deterred investors. But in fact, six (Saudi

Arabia, Qatar, Kuwait, Oman, Nigeria and Peru) of the top 10 of

most resilient economies in the BofA ML Global Research ranking

(which measures important economic indicators such as fiscal

position and current account balance) are frontier markets or

smaller emerging countries (see Exhibit 11). Many of the high-

ranked frontier markets have high prospective growth rates,

favorable demographics, large current account, fiscal surpluses

and lower public debt, trade on undemanding valuations (many trade on discounts to larger EM when

compared to their own history) and have improving and deepening capital markets. Most private

clients are unlikely to have investment exposure to many of those top ranked economies. Again,

though, as can be seen by the fact that several of the lowest-ranked countries are frontier markets,

too, there is a requirement to differentiate within these market classifications, as well.

While most individual investors remain underexposed to these

frontier markets, the global investment community is becoming

more comfortable with allocating to the space as recognition rises

of the relatively stronger growth story there. Year-to-date, global

frontier funds have seen inflows exceeding 40% of their assets

under management, a trend we expect to continue (see Exhibit

12). Within a low-but-improving growth world, opportunities for

higher growth should still prevail, leading the case for frontier

markets. Furthermore, we believe sufficient global liquidity and

the reduction of tail-risks (primarily in Europe and with regards

to the U.S. fiscal cliff) will cause investors to take opportunities

within markets they have previously perceived as being too risky.

Two additional factors, in our view, support the ongoing attraction

0 10 20 30 40 50

Top 10

Bottom 10

LebanonSerbia

UkraineGhana

MoroccoEgypt

SloveniaSouth Africa

JordanCroatia

GabonPeruIraq

NigeriaTaiwanChinaOman

KuwaitQatar

Saudi Arabia

Aver

age

Exhibit 11: Top 10 most resilient economies are dominated by frontier markets

Source: BofA Merrill Lynch Global Research, IMG. Data as of June 2013.

Global frontier �ows, 10-wk ch. (US$m)MSCI Frontier perf. vs. MSCI EM (Right)

Mar-12 Jul-12 Nov-12 Mar-13-50

50

150

250

350

450

550

650

750

98102106110114118122126130134138

Exhibit 12: Investors attracted to frontier markets as performance impresses

Source: EPFR, Datastream, BofA ML Global Research, IMG. Data as of July 2013.


of frontier markets. First, several frontier markets will over the next few years be upgraded toward

EM status, leading to significant fund inflows. Second, a growing recognition that frontier markets

are not just commodity dependent or an oil play but actually a good way to get exposure to the

growth of consumers within the developing world should reduce a perceived risk of the region. As

BofA ML Global Research has shown, while the degree to which

commodities drive the economy varies across countries, overall

they are less significant to market performance than people might

realize, with many frontier markets actually outperforming larger

EM during oil price declines.

As Exhibit 13 shows, frontier markets (as measured by the

MSCI Frontier Emerging Market Index) have performed much

stronger than the larger country Emerging Market Index since

the beginning of 2013. Our colleague Michael Harris, EEMEA

Investment Strategist for BofA ML Global Research, currently

recommends an overweight to frontier markets within Emerging

Europe, Middle East and Africa (EEMEA).

BRIC markets outlookChina“ In our discussions with the authorities, they emphasized their intention to embark on a comprehensive

reform agenda that will ensure more balanced, inclusive and environmentally friendly growth going

forward. While China still has significant policy space and financial capacity to maintain stability even

in the face of adverse shocks, the margins of safety are narrowing and a decisive impetus to reforms is

needed to contain vulnerabilities and move the economy to a more sustainable growth path.”1

In previous episodes of economic slowdown, the de-facto policy response of Chinese leaders was

to ease monetary and fiscal policy. This time, however, Chinese officials have broken from tradition.

Under the leadership of new Premier Li Keqiang, financial and monetary conditions have been

tightening so as to reign in the growing shadow banking system and deliver a less credit-fueled

longer-term growth rate. The new policymakers appear to have been more willing to let the economy

slow, focusing instead on reform to support medium-term growth. In retrospect, this tighter policy

stance was more than we had expected. Premier Li has emphasized the need to maintain GDP

growth above a minimum threshold (likely 7.5%), but the tightening in financial conditions and the

clampdown on shadow banking have reduced private sector demand, reducing the likelihood of a

sharp rebound in the economy.

Frontier Markets Emerging Markets Developed Markets

80

85

90

95

100

105

110

115

120

Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13

Exhibit 13: Frontier markets have outperformed EM so far this year

Source: Bloomberg, IMG. Data as of July 2013.

Portfolio Strategy: We believe investors should look beyond BRICs when allocating to EM.

Select, smaller, non-BRIC EM should benefit more from an improving U.S. economy and may

prove less vulnerable to higher U.S. interest rates. Furthermore, we think a focus on frontier

markets, which have performed better than larger EM equities this year, should be included. We

prefer flexible, active managers that are not constrained by BRIC and EM benchmarks.

1 IMF 2013 Article IV Consultation Discussions with China, May 28, 2013


As such, expectations for 2013 Chinese GDP have been

persistently downgraded by economists (see Exhibit 14). Ting Lu,

BofA ML Global Research Chief China economist, recently reduced

his forecast for Chinese GDP growth in 2013 and 2014 to 7.6%

each year, from 8.0% and 7.7%, respectively, on the expectation of

weaker exports and slower inventory restocking.

Focusing on equity markets, Chinese equities have had a horrid

2013, down 7% year-to-date in total return U.S. dollar terms

(as measured by the MSCI China Index), underperforming the

S&P 500 Index by over 20 percentage points. Corporate profit

margins too have fallen significantly in recent years (see Exhibit

15) and earnings have trended downwards. The slower earnings

growth can be largely attributed to weaker domestic and global

economies and tighter domestic credit conditions.

Sentiment on Chinese equities has fallen to very low levels (see

Exhibit 16). The good news is low equity valuations (see Exhibit

17) should limit significantly further relative underperformance

from here, in our view. The re-affirmation of Premier Li to not

let growth go below a minimum level and the stabilization in

interbank funding markets has calmed investors and led to a

tactical bounce. As highlighted by our colleague BofAML Global

Research Chief Global Investment Strategist Michael Hartnett,

tactical trading indicators show this bounce may continue over the

short term (see Exhibit 18 on the next page).

For the bounce to turn into a more sustainable uptrend in

China, however, we think we need to see evidence of stronger

profitability from Chinese companies, higher corporate ROE, an

easing in financial conditions and a bottom in the earnings revision

cycle. These indications, combined with attractive valuations,

China Consensus 2013 GDP Growth (%)

7.5

7.7

7.9

8.1

8.3

8.5

Jul-12 Oct-12 Jan-13 Apr-13 Jul-13

Exhibit 14: Expectations of 2013 China growth have been revised markedly lower

Source: Bloomberg, IMG. Data as of July 2013.

China Pro�t Margins (%)2006 2007 2008 2009 2010 2011 2012 2013 9

10

11

12

13

14

15

Exhibit 15: China profit margins have declined in recent years

Source: Datastream, BofA ML Global Research, IMG. Data as of June 2013.

China 12m forward PE

7

9

11

13

15

17

19

21

23

25

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Exhibit 17: Chinese equity valuations almost back to levels of the financial crisis

Source: Factset, IMG. Data as of June 2013.

0 5 10 15 20 25 30 35 40 45 50 55 60Jun-13 Jul-13

In�ation

US �scal tightening

Other* (*please specify)

Failure of “Abenomics”

Geopolitical crisis

EU sovereign/banking crisis

China hard landing & commodity collapse

Exhibit 16: Sentiment on China has declined as investors become more concerned with a hard landing



would give us comfort that investors have sufficiently discounted

the new growth model at a time when fundamentals are again

improving, but we are not there yet.

BrazilIn Brazil, economic activity continues to weaken. Domestic

household indicators remain soft, with the retail sector particularly

disappointing. As such, BofA ML Global Research Brazil Economist

David Beker believes that the Brazilian economy may grow as

slowly as 2% in 2013, with only a slow pickup to 2.6% in 2014

(see Exhibit 19). The combination of high inflation and rising

inflation expectations, tighter monetary policy, slow economic

growth and concerns over higher unemployment have all led to a

huge decline in President Dilma Rousseff’s approval rating. Greater

political instability has also weighed on markets.

Focusing on equities, the Brazilian market has declined by 17%

year to date. Our colleagues in BofA ML Global Research acknowledge that risks to Brazilian equities

remain to the downside. The combination of a negative macro environment combined with declining

profit margins could see earnings expectations further under pressure. But it is clear that investor

sentiment on Brazil has collapsed, which could lead to a rebound from the bottom. Still, within Brazil,

the focus should be on sector- and company-specific opportunities, in our opinion, rather than allocating

to the broad index. The combination of slowing growth and still-high inflation indicates to us the nation

is under-invested, a feeling shared by the IMF in its recent economic outlook press conference. We

believe there will be better investment trends in the years ahead that companies can benefit from. As

highlighted by BofA ML Latin America Equity Strategist Felipe Hirai, there are segments of the market

that remain attractive, such as capital goods, large-cap banks and sectors linked to increasing education

levels. Further, moving away from allocating solely to the index reduces the concentration in some

heavily represented materials and energy companies, which may struggle more.

Portfolio Strategy: Further significant short-term downside

in Chinese equities is limited, in our view, given current

valuations. Deeply negative sentiment may allow this current

rebound to continue short-term but the ride will likely be

bumpy. Yet, a catalyst for a significant re-rating is still some

time away as investors get used to a new growth model with

tighter credit conditions. We do not think investors should

run head-long toward Chinese equities at present. Where

allocated, focus on the winners of the new growth model—

investments linked to the growth of the Chinese consumer,

the aging population, companies with higher earnings quality,

and those focused on higher value added production. Active

managers can identify structural winners as China’s economy

rebalances toward private sector spending.

5/10 9/10 1/11 5/11 9/11 1/12 5/12 9/12 9/131/13 5/1330

35

40

45

50

55

Soft buy-signal

Dec'12 sell-signal

Sell-signalSell-signal

Sell-signal

Soft buy-signal

Sell-signal

EEMPrice Performance

Exhibit 18: BofA ML Global Research trading rule signals short-term upside for EM


4Q12 1Q13 2Q13F 3Q13F 4Q13F Averages (2012and 2013F)YoY % change QoQ % change

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

Exhibit 19: Brazilian GDP to remain low through 2013



IndiaThe Indian economy has slowed meaningfully from a peak rate of

nearly 12% year-on-year in first quarter of 2010 to a low of 4.7%

year-on-year at the end of 2012 due to tightening by the Reserve

Bank of India (RBI), a slower global economy, weak domestic

investment, poor rains, and limited structural reform adopted by a

challenged government. The good news for the Indian economy is

that, as highlighted by BofA ML Global Research India economist

Indranil Sen Gupta, the worst is likely now passed (see Table 1).

However, that does not necessarily equate to a surging recovery.

Rather, the economy is likely to remain stagnating around the

5-6% annual growth rate, well below the potential capacity. Much

like Brazil, the economy faces far too high an inflation rate given

the recent cooling in growth.

The equity market has proved particularly resilient in local currency

terms, yet the currency has weakened substantially. With the Indian economy running twin current

account and budget deficits, the bias for the currency is to weaken on bouts of global investor

risk aversion or any further disappointment in the Indian economy. Corporate earnings could be

downgraded further, although there is more positive news on margins, which are expected to show

a year-on-year improvement. At 13.1 times the 12-month forward price to earnings ratio, the Indian

market is starting to offer value, especially if we have passed the peak in the tightening cycle as

inflation moderates in the second half of 2013 and the election next year allows for more reform and

investment. We would look to start dipping our toes back into the Indian market on expectation of

monetary easing, a healthy monsoon season, support to margins, and a pick-up in reforms in 2014.

Investors mindful of adding too much risk should manage the currency exposure by hedging the

rupee to mitigate against the risk of further investor apprehension.

Portfolio Strategy: The market is beginning to offer value, especially if we have passed the

worst of the economic and earnings cycle. This may prove early as much will depend on the

run up to the election yet within the BRIC markets, the outlook is relatively better, although

we note that India has remained a destination of choice for EM investors so far this year. To

reduce risk, our preference is for defensive companies and to hedge the currency.

Sector Jan-10 Dec-11 Apr-12 Current

Real cash demand Positive Negative Positive Positive

Industrial production Industry Positive Negative Negative Negative

Credit Industry, services Neutral Neutral Negative Negative

Capex Industry Positive Negative Negative Negative

Business Confidence Index Industry, services Positive Negative Neutral Neutral

Earnings Industry, services Positive Negative Neutral Neutral

Construction Industry, services Positive Neutral Neutral Neutral

Traffic Industry Positive Neutral Neutral Neutral

Telecom subscribers Services Neutral Neutral Neutral Neutral

OECD lead indicator Industry, services Positive Negative Neutral Neutral

Table 1: India’s indicators pointing to stabilization, yet improvement from H1 2013


Portfolio Strategy: The combination of higher inflation, weak activity, a tightening central

bank, falling profit margins and under pressure earnings warrants a cautious view on Brazilian

equities. Within the headline index, there are attractively valued opportunities linked to the

need to increase investment spending and supply side reform. We think investors should focus

on these instead of broad Brazilian equities, which are overly concentrated on few stocks.


RussiaOur colleagues in BofA ML Global Research forecast the Russian economy to grow by 2.9% in

2013, before accelerating modestly to 3.1% next year. The IMF forecasts an average annual

growth rate between 2013 and 2016 to be 3.6%, down from an average of nearly 7% between

2000 and 2008. The principal driver in pre-crisis economic growth was the rise in productivity, but

this has now reduced substantially. With Russian demographics unfavorable over the medium term,

Russia needs increased capital investment. The government appears to be taking very modest

steps toward that end, yet the fiscal position remains at risk should oil prices begin to falter. In

regards to monetary policy, the CRB (Central Bank of the Russian

Federation) could ease policy through year end as inflation

pressures remain low in the face of the economy’s overcapacity

and negative output gap.

Focusing on equities, the Russian market trades on exceptionally

cheap valuations (see Exhibit 20). This has been true for several

years, though, and is not necessarily a catalyst for considerable

future performance. Still, the combination of the low valuations,

high and presently rising oil prices, the possibility of central bank

monetary easing and more favorable investment could lead to

Russia outperforming some other BRIC markets over the coming

quarters. (Historically, Russia is less vulnerable to rising nominal

U.S. bond yields, too). Harris currently prefers to be overweight

Russia on the possibility of outperformance through the third

quarter, with a preference for consumer and banking stocks.

We stress, however, our belief in more active management when

considering Russian equities. Passive vehicles that track either the

MSCI Russia Index or the local Micex Index have incredibly high

stock concentrations. For example, half the index consists of just

three stocks.

A CHANGE in HOW we investOver the recent quarters, we have written frequently about the way we believe clients should be

investing in EM. Last September, we discussed the need to rethink how to invest in EM (CIO Monthly

Letter, Rethinking Emerging Market Portfolios, September 2012), acknowledging four key elements: 1)

the role of multinational companies, 2) the role of local winners, 3) the bigger role for countries and

sectors over homogenous “regions” and 4) a preference for active management over passive exposure.

In discussing the new growth models of many EM, we re-affirm the need to be more granulated when

Portfolio Strategy: Russian equities trade on exceptionally low relative valuations which,

combined with easier monetary conditions, low investor positioning and high oil prices, could

lead to tactical outperformance to other BRIC markets in third quarter. We believe Russian

equities are best allocated to active investment vehicles as part of a broader Emerging Market

allocation, given worryingly high stock concentration with passive investments.

Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

Russia, 12m fwd P/E rel. to EM

+1 std dev

-1 std dev

Exhibit 20: Russian equities trade on very cheap relative valuations


Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12-70%

Russia, 12m fwd P/E rel. to EM

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

+1 std dev

-1 std dev


investing, stressing the need to focus on country and sector themes tied to local growth stories, rather

than broad allocation to EM as a region, and to favor active over passive exposure.

When looking at passive investments replicating EM, we believe

the index composition reflects the historic stories of EM rather

than the best positioning for the future ones. This can be shown

when breaking down the index by countries and sectors. Focusing

on countries, the EM Index has a very large allocation to BRIC

markets (see Exhibit 21), which, as we have argued above,

are not currently the best opportunities. Looking at a country

concentration, it can be seen that almost two thirds of the index

weighting comes from just the five largest countries.

Instead, for example, allocating an equal amount to each EM

country within the MSCI Emerging Market Index, rather than

allocating to the EM Index, would have been a more beneficial

strategy (see Exhibit 22).

The reason for this is because the eight best-performing EM

countries since 2003 (Colombia, Peru, Egypt, Indonesia, Brazil,

Turkey, Chile, and Thailand) have less than a 25% allocation in

passive funds replicating the EM Index, while the eight worst-

performing countries have a 55% allocation. It’s clear then how an

active approach to country allocation would have better captured

the performance of the best-performing markets.

A similar story can be seen when looking at a sector breakdown

of passive investments. These are often over concentrated in

materials and energy, which benefited most from the largest

drivers of growth from the last decade. The largest drivers of

the next decade—the consumption and reform cycle benefiting

the consumer-related sectors such as consumer staples, discretionary and healthcare—are far less

represented in the index. Furthermore, unlike in the developed world where the largest companies in

the index owe their place to persistent, successful, profitable growth, the largest companies in the

EM index are often state-driven, static, conglomerate companies with low profitability. The use of

active management with local knowledge can therefore avoid less profitable companies and sectors.

So, while exchange-traded funds (ETFs) that track national or regional stock indexes can be a useful

way to take advantage of global growth, in the current environment actively managed funds may be a

more effective way to help investors navigate markets that may not be as familiar to them—such as

EM and frontier markets.

Equal Weighted Emerging Market IndexMSCI Emerging Market Index

0

100

200

300

400

500

600

700

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Exhibit 22: Higher allocation to smaller EM has historically outperformed

Source: Factset, IMG. Data as of end 2012.

5 largest countries (Right)BRIC concentration

50

52

54

56

58

60

62

64

66

68

0 5

10 15 20 25 30 35 40 45 50

2005 2006 2007 2008 2009 2010 2011 2012

Exhibit 21: Index funds have high concentration to few countries (% of total EM Index)

Source: Factset, IMG. Data as of end 2012.

Portfolio Strategy: We believe investors need to CHANGE the way they invest within EM.

Instead of large allocations to passive investments representing EM indices that are over

allocated to large and in our view weaker performing EM countries, flexible active managers can

avail of the country and sector specific trends that better represent the growth prospects of the

future, including smaller EM and frontier markets.


APPENDIX

Contributing Author: Chris Wolfe

Emerging Markets vs. Frontier Markets

EMERGING MARKETS FRONTIER MARKETS

AmericasEurope, Middle

East & Africa Asia Americas Europe & CIS Africa Middle East Asia

BrazilChile

ColombiaMexico

Peru

Czech RepublicEgypt

Greece3

HungaryPolandQatar4

RussiaSouth Africa

TurkeyUnited Arab Emirates4

ChinaIndia

IndonesiaKorea

MalaysiaPhilippines

TaiwanThailand

ArgentinaJamaica1

Trinidad & Tobago1

Bosnia Herzegovina1

BulgariaCroatiaEstonia

LithuaniaKazakhstanRomaniaSerbia

SloveniaUkraine

Botswana1

Ghana1

KenyaMorocco3

MauritiusNigeriaTunisia

Zimbabwe1

BahrainJordanKuwait

LebanonOman

Saudi Arabia2

Palestine1

BangladeshPakistanSri LankaVietnam

1 The MSCI Bosnia Herzegovina Index, the MCSI Botswana Index, the MSCI Ghana Index, the MSCI Jamaica Index, the MSCI Trinidad & Tobago Index, the MSCI Zimbabwe Index, the MSCI Palestine IMI are currently stand-alone country indices and are not included in the MSCI Frontier Markets Index. The addition of these country indices to the MSCI Frontier Markets Index is under consideration.

2 The MSCI Saudi Arabia Index is currently not included in the MSCI Frontier Markets Index but is part of the MSCI Gulf Cooperation Council (GCC) Countries Index.

3 Effective November 2013, Greece is reclassified from Developed Markets to Emerging Markets, and Morocco is reclassified from Emerging Markets to Frontier Markets.

4 Effective May 2014, Qatar and the United Arab Emirates are classified from Frontier Markets to Emerging Markets.

Source: MSCI, IMG.

Spencer Boggess, CIO, Alternative Investments212-448-2043

Anil Suri, CIO, Multi-Asset Class Modeled Solutions212-449-3385

Chris Wolfe, CIO, PBIG and Ultra-High Net Worth Customized Solutions212-236-3159

Jim Russell, CIO, Portfolio Construction and Multi-Manager Solutions201-557-0079

Mary Ann Bartels, CIO, Portfolio Strategies646-855-0206

Victoria Ip, Chief Investment Strategist, Asia-Pacific Rim852-3508-5305

Johannes Jooste,Chief Investment Strategist, EMEA44-207-9964686

ThE CIO TEam

GWM Investment Management & Guidance (IMG) provides industry-leading investment solutions, portfolio construction advice and wealth management guidance. This material was prepared by the Investment Management & Guidance Group (IMG) and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of IMG only and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available.

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