global investing in emerging markets

CFA Institute

Global Investing in Emerging MarketsAuthor(s): Jarrod W. WilcoxSource: Financial Analysts Journal, Vol. 48, No. 1 (Jan. - Feb., 1992), pp. 15-19Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4479500 .

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Current Issues

Global Investing in Emerging Markets

by Jarrod W. Wilcox, Batterymarch Financial Management

Would it be risky to recommend that your company invest 10 per cent of its total pension fund in stock markets in Indonesia, Brazil and similar places? Of course it would.

Six years ago, I said in a speech that "Many firms are in the early stages of redeploying their as- sets-up to a third in some cas- es-to markets outside the U.S." This sounded pretty outlandish at the time; typical international commitments were closer to 3 than to 30 per cent. But today, consultants are beginning to edge toward the latter figure. Many companies are moving from 5 to 10 per cent and beyond.

Six years ago, most investors would have said that much international investing was too risky, even though more foreign diversification would clearly have reduced portfolio volatility, despite currency risks. What they meant, of course, was risky to them. Their risk aversion has declined as opinion-leading pension funds have pioneered the way to higher international exposure. Interna- tional investing has become a mainstream event.

Investing in less developed markets today looks to me very much like investing in Germany, Japan and the United Kingdom did a decade ago. Of course, emerging markets are different from developed markets, they are much smaller and riskier. Yet five years from now, many large pension funds will be well on their way to a 5 per cent commitment in today's emerging markets. I expect

this commitment will eventually expand to 10 per cent, because some of these markets will see explosions in value, allowing them to absorb much more fund- ing. Opening up your own port- folios to that progress will not seem particularly risky; it will be inevitable.

By emerging markets, I mean equity markets in countries with low gross domestic product (GDP) per capita. Examples include Mexico, Brazil, Malaysia, Thai- land, Taiwan, Korea, India, Tur- key and Nigeria. We can also expect new markets in Eastern European countries, mainland China and the Soviet Union to become practical alternatives. Within the last few years Hong Kong and Singapore have gradu- ated from the list of emerging countries, although they retain

political risks characteristic of emerging markets.

I'd like to share four ideas that make me personally enthusiastic about investing in these countries.

The Risk-Return Tradeoff The investment appeal of emerging markets in terms of risk and return is already very high. The global investor experiences only a small part of the often enormous volatility confronting the purely local investor. Table I sum- marizes five-year U.S.-dollar monthly returns of the Interna- tional Finance Corporation (IFC) composite index of emerging markets. Future risks are estimated to be similar to those of the last five years. Theoretical future average returns may conser- vatively be expected to continue

Table I Emerging Market Risk and Return

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(S&P Developed Emerging 500) (EAFE) (IFCC) <

Correlations 1.00 0.45 0.37 2

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Annualized 17.7 18.2 24.5 B Risk (%)z

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Practical Avg. 12.0 11.2 12.3 t

Return (%)b z

Source: U.S.-dollar monthly returns for the 60 months ending December 1990 from International Finance Corporation. Z a. Theoretical return = 6% risk-free return + (6/17.7) risk. The price for risk assumes a 6% risk z premium for the S&P 500. b. Practical return = theoretical return less 1.0% for incremental international costs or 2.0% for emerging-market costs (taxes, custody, trading). 15



Figure A A Typology of Market Participants

Trend Followers Price-Momentum Traders

(The Crowd)

Information-Momentum Traders

New-Information Passive

Traders Traders

Value Investors

Trend Reversers

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at least in rough proportion to the volatilities shown.

A still more conservative case (practical average returns) assumes additional taxes and trading costs. Even then, a typical optimal portfolio would have at least 15 per cent in emerging markets. (Quarterly data show higher correlations, but the order of magnitude of return differ- ences still holds.) As the staffs of large pension funds become more sophisticated, investment in emerging markets will be tested and then it will grow.

Of course, careful diversification is essential to these benefits. The cumulative 1990 five-year return of the IFC index for Chile was over 800 per cent. At the other extreme, however, an investment in Brazil would have been down 65 per cent. A passive index strat- egy has considerable appeal. I believe active investing may be even better.

The Global Investor Can Add Value

My second idea is that emerging markets are attractive to global investors because of the different stages in the evolution of market participants. These are illustrated in Figure A. New stock markets begin with little trading, most of it carried out between passive investors and market-makers. Cor- porate insiders, when they do trade, have a great information advantage. As a market develops, it attracts professional investors, who attempt to use fundamental information before others can fully exploit it. These investors are predominantly momentum players. They try to ride a wave of new information coming into the market.

As a market matures, large num- bers of amateur active investors join in. Many require no new fundamental information; they simply amplify existing price trends. Such markets exhibit very wide swings in valuation versus

tangible information. Crowd psy- chology often governs.

As a market develops still further, the availability of public data leads to the prosperity and in- creased presence of so-called value investors. These decision- makers profit from extremes by comparing prices with measures of long-term intrinsic value. By investing against the trends, they dampen fluctuations. Finally, public data and deep reserves of interested parties with varied and sophisticated decision rules make the market efficient.

There is little in the way of con- crete evidence for this vision of market development. I do know, however, that simplistic rules for buying stocks based on the ratio of price to published earnings and other data have historically provided superior returns both in the U.S. and internationally. Dur- ing the last five years, the success of such rules in the U.S. appears to have been confined to rare episodes. But traditional value- based approaches have had more continued success in the possibly less sophisticated markets of Eu- rope and the Far East.

Emerging markets seem even more immature than Europe or the Far East. Judging from their enormous volatility, I hypothesize that they lack enough value- oriented investors. With comput- er-readable public data on hun- dreds of stocks in emerging markets, a global value-oriented investor could logically hope to enjoy superior returns, despite disadvantages in obtaining non- public information.

Expertise in Development Economics

A third reason why emerging markets may be attractive is that they are imperfectly integrated with the world capital market. We should look closely at the country as a unit of analysis. If we have a better forecast of real growth than other global investors have, we might realize better long-term stock returns. This benefit will



Table II Predictors of Real Growth

Variables RGROWTH = Annual percentage growth in GDP, adjusted for local inflation, 1984 through last year available PCTFI84 = Fixed investment percentage of GDP, 1984 PCTGC84 = Government consumption percentage of GDP, 1984 LNPERCAP = GDP per capita in U.S. dollars, 1984 (log form) LNINFLAT = Annual percentage inflation, 1984 through last year available (log form) POPGRWTH = Annual percentage population growth, 1984 through last year available

Multiple Regression (t-statistics in parentheses): 71 countries: RGROWTH = 10.0 + 0.052 PCTFI84 - 0.071 - PCTGC84 - 0.743 . LNPERCAP

(5.1) (1.2) (-1.7) (-3.0) -2.10 LNINFLAT - 0.417 POPGRWTH; R-Squared = 0.33

(-3.3) (-1.8) 30 countries: RGROWTH = 13.5 + 0.093 PCTFI84 - 0.117 PCTGC84 - 1.07 LNPERCAP

(3.8) (2.1) (-1.9) (-2.5) -2.16. LNINFLAT - 0.511. POPGRWTH; R-Squared = 0.54

(-2.6) (-1.2)

Source: International Financial Statistics, International Monetary Fund, May 1991.

complement any skill as a value investor.

I apologize in advance to development economists for my crude analysis; a careful study of their work seems warranted. With that caveat, what might be helpful to an investor interested in predict- ing real growth by country? Data from the International Monetary Fund on national accounts, local inflation, currency exchange rates and population are available for 71 countries (if we include a few with 1988 and 1989 still unreport- ed). We can examine real growth for as much of the five-year period through 1989 as is available.

I explored five, and only five, possible predictive variables; all showed at least some relevance. Table II shows the estimated multiple regression equation, both for this sample and a subset of 30 countries for which stock return data are also available. I mea- sured real economic growth as 1984-89 percentage growth in GDP, adjusted for local inflation. It is positively related to 1984 fixed investment as a percentage of GDP and negatively related to 1984 GDP per capita and 1984 government consumption as a

percentage of GDP. Real GDP growth is also related negatively to both the coincident rate of inflation and the coincident rate of population growth. Although the last relationship is weak, it is surprising, because we were not

trying to predict real growth per capita.

Figure B illustrates the strong im- pacts of the percentages of the economy devoted to fixed investment and to government con-

Figure B What is Good Government?

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generally those with least GDP per capita and most return volatility. Even if accurate, some or all of the effect may reflect a fluctu- ating risk factor that was negative in this period. One suspects that population growth, including both net births and net immigration, is a coincident indicator of an unmeasured, unanticipated factor that impedes progress.

Countries Moving Toward Market Freedom

The recent emergence of China and the republics of the Soviet Union as potentially market- oriented societies, together with the earlier positive examples of the smaller Asian economies such as Korea, Taiwan, Singapore and Hong Kong, have stimulated countries around the world to take steps toward free markets.

sumption by plotting their differ- ence as a predictor of real growth. That government seems best which governs least-and in- vests most.

Data on U.S.-dollar-denominated returns for 30 developed and emerging markets for the five- year period ending December 1989 are available separately from Morgan Stanley and International Finance Corporation. What hap- pens when we use our real growth predictors to see if they can provide any clues as to country stock index returns? This question could be better an- swered if we knew existing levels of valuation, from which we might infer the market's growth anticipations. Even in that context only the unanticipated predictors of real growth should show any correlation with returns. Still, we may see something.

Of the five predictors, only the weakest-coincident population growth-is helpful in explaining 1984-89 stock returns. The strong negative relation (see Figure C) is probably overstated; the high- population-growth countries are

Table III Ladder of Free Markets

Cross-Border Markets Foreigners allowed to buy control Foreigners allowed to issue securities Capital crosses borders freely Foreign subsidiaries can remit profits Foreign ownership allowed Foreign joint ventures allowed Immigration, emigration Foreign purchase of property Tariffs limited to infant industries

Enterprise control Absence of barriers to takeovers No restrictions on ownership Freedom from government direction

Capital Freedom to issue stock Stock market Bond market Competitive interest rates Private, competitive banks Businesses allowed to keep profits

Goods Manufacture or Import Right to private import for resale Freedom to start new business No unpaid governmental seizure Private manufacturing Freedom to choose products, suppliers Competitive pricing to government

Housing Location Contractors freely erect buildings Private housing ownership Workers move without permission

Labor Women participate freely Employers can hire and fire Competitive wages Workers can select among employers

Trade Free entry into trades Competitive pricing of goods Private shops

Agriculture Freedom to buy and sell land Private farmland Farmers' markets Freedom of serfs to leave land



Markets in goods, labor, housing, capital and, finally, enterprise control are gradually coming into being, often across country boundaries. These create the conditions necessary to "catch up" to the most developed economies. Even modest improvements in these conditions have been associated with great upsurges in stock markets in Korea and Tai- wan, and then in Thailand, Turkey and, perhaps, Chile. Valuation of the resulting future improvements provides an opportunity for inordinate investment returns.

The underlying steps toward freedom occur intermittently. Global investment activity, by rewarding the most progressive sectors of each country, can accelerate the process. The more market freedom is allowed, the greater a country's long-term ability to in- novate and to make real economic progress. Frequently, however, the steps taken will be backward-based on reactions to injuries to social status, wealth, power, religious beliefs or other social values.

Table III provides an ordered check-list, with the most ad- vanced steps at the top, that can be used to assess the progress of emerging countries. It reminds us, for example, that the free entry of women into the job market is associated with more developed economies, which also have lower population growth rates. I believe that skill in sensing steps up the ladder, and their threat- ened retracement, is very helpful in country selection.

It may not be true that "greed is good." In this instance, however, it does appear that the pursuit of profit by global investors is helpful to the pursuit of a higher standard of living in developing countries.

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