Download Sparinvest White paper - Risk Containment in Emerging Markets

Risk Containment in Emerging Markets –
Whether to Track or Crack an Index?
White Paper
By Professor Dr Leif Hasager and Sidsel Møller, MSc. (Economics)
Risk Containment in Emerging Markets
Executive summary ........................................................................................... 3
Emerging markets – have risk-averse investors missed the boat? ................................... 4
Emerging Markets have delivered stronger returns than Global Markets ............................ 4
Growth in emerging markets ................................................................................ 5
Is GDP growth a prerequisite for equity returns? ....................................................... 6
The index approach........................................................................................... 7
Risk factors in emerging markets .......................................................................... 7
Empirical Evidence: Value Adds Value in Emerging Markets ..........................................10
Why opt for active management? ........................................................................ 11
Growth vs. lack of growth – how value can work in both environments ......................... 12
Conclusion .................................................................................................... 12
References.................................................................................................... 13
Definition of Developed, Emerging and Frontier Markets ........................................... 13
About Leif Hasager .......................................................................................... 13
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Risk Containment in Emerging Markets
Executive summary

Given their rise to economic power and track record of investment outperformance,
emerging markets demand a substantial portfolio allocation.

Academic evidence shows that value investment enhances the returns available from
emerging market equity investment. Even a passive exposure to undervalued equities
represented by the MSCI Emerging Markets Value index would have delivered vastly
superior returns to the wider MSCI Emerging Markets index over the past decade.

The problems associated with index compilation are particularly acute in emerging markets
where size and liquidity factors can skew benchmarks. Furthermore, benchmarks are not
able to address the numerous risk factors that can discourage people from investing in
emerging markets.

In recent years, as a result of huge flows of money into emerging markets, the new
concern is that some parts of the universe could be priced too expensively, meaning that
the „emerging risk‟ of emerging market participation is that of paying too much.

Active management has the advantage of integrating risk factors into investment decisionmaking and, through fundamental analysis, the value strategy also avoids buying equities
that have become too expensive.

A true value investor will therefore apply a bottom-up process that of course may deliver a
portfolio that deviates considerably - in terms of geographical or sector allocation - from
the value reference. The portfolio will however deliver „purer‟ value than index tracking,
giving better long-term risk / return characteristics.

A value strategy is also „future-proof‟ in emerging markets because it is not reliant on a
continuation of high rates of economic growth to succeed. In fact, as emerging markets
become more mature, they can offer benefits that support an active value strategy more
effectively. The only requirement for value investment to work is that stock markets
should continue to generate and correct pricing inefficiencies
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Risk Containment in Emerging Markets
Emerging markets – have risk-averse investors missed the boat?
With IMF predictions indicating that they will have a 50% share of world GDP by 2020, the „topdown‟ economic argument for investment exposure to emerging markets is compelling. At the
same time, with growth in mature markets becoming as rare as hens‟ teeth, demand for
emerging markets securities is likely to remain high for the foreseeable future, boosting
potential returns and providing healthy levels of liquidity. The rapid economic evolution of the
emerging markets in recent years, and predictions for continuing growth, are strong arguments
for why investors should have a large (and growing) allocation to them in a well-diversified
portfolio. But the most risk-averse investors have resisted the attractions of these markets
precisely because of their reputation for involving additional risk. The intention of this paper is
to review emerging market-specific risks and consider whether they are compensated by the
potential rewards of investment.
As the emerging market investment universe becomes more mature, and transparency increases
at all levels, many of the traditional resistance points for risk-averse investors have eroded. For
example, in order to operate effectively in the global economy, most emerging market
companies now use internationally-accepted accounting standards and reputable auditors. As
time has passed, the financial information required by stock-pickers – such as corporate
performance over complete economic cycles – has become available, adding further clarity to
investment decision-making. And while their economies and stock markets have been maturing,
emerging markets equities have also been outperforming the global equity universe. In fact, over
the past decade in particular, outperformance has been remarkable, with average annualized
outperformance reaching double digits, as shown in Figure 1 below.
Emerging Markets have delivered stronger returns than Global Markets
1,600
1,400
1,200
MSCI Em Mkts USD
MSCI World USD
1,000
800
600
400
200
1987
1989
1990
1991
1992
1993
1994
1996
1997
1998
1999
2000
2001
2003
2004
2005
2006
2007
2008
2010
2011
0
Figure 1, Source: MSCI
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Risk Containment in Emerging Markets
The question, of course, is whether this outperformance is likely to continue in the future. For
this we should perhaps spend some time considering the questions of:
1) Why emerging markets are expected to continue to grow faster than the rest of the
world? and
2) Whether, as a general principle, GDP growth necessarily translates into equity returns?
Growth in emerging markets
The following chart plots world GDP from the year 1AD until 2040, when emerging market
nations are expected to „revert to normal‟ and have the lion‟s share of economic output. The
„norm‟, established in years 1-1000, is based on the calculation of population in a given region
against a calculation of its wealth. In fact, the key indicator for a nation‟s wealth is its
productive population.
What is happening with „back to normal‟ is that the poorer countries are catching up with the
richer countries. The fall of the Berlin Wall was the watershed for this process. Before that, a
large proportion of the planet was experimenting with an inefficient economic system – Russia,
Eastern Europe, China and a lot of Third World countries were kept in an underdeveloped state.
When these countries started to embrace the market economy, the GDP growth of the emerging
markets really began. Why will this process continue to 2040 and beyond? It will continue
because there are no longer any „barriers to entry‟ in the world economy. There is no reason for
any one region to be richer on a per capita basis than any other – as there is a readily available
blueprint for economic development [cf Mills, 2010]. We must therefore assume a more even
distribution of wealth is inevitable.
Figure 2. Source Maddison and own forecasts
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Risk Containment in Emerging Markets
In recent years, emerging market economic growth has been strong, and equity market returns
have been solid. Going forward, the „back to normal‟ process should mean the continuation of
attractive growth, but of course, longer-term, emerging market growth must gradually slow
down. This is however many years down the road and need not concern us unduly now.
Is GDP growth a prerequisite for equity returns?
There is a lot of conflicting research on the link between GDP growth and equity returns. Some
studies suggest there is a correlation; others say there is no correlation [cf e.g. Vanguard, 2010
or Ritter, 2004]. There is no definitive answer to this question.
On the one hand:
 Theoretically, growth tends to be an anchor for overall equity market return
 Growth by itself attracts a lot of investors and therefore makes markets larger and more
efficient, warranting higher multiples
 Institutional participation in a market is often correlated with growth and leads to greater
stability and, again, higher multiples.
On the other hand:
 Overinvestment can cause a low return on invested capital
 Growth could primarily be in the non-listed sectors – entire countries without a stock
exchange (Madagascar, Albania, Dominican Republic belong in this category) or growth
might take place in companies listed in other countries
 Growth may be priced in already.
On balance, one could say that growth is likely to support equity market returns – but one should
not equate growth with returns.
The growth story is an argument for establishing a substantial strategic allocation to emerging
markets as a whole but the GDP growth figures of individual nations should not be used to
prioritise investment in one market over another.
Also, from a diversification point of view, an investor should use the entire investment universe
and - on average - invest in markets according to the position of importance that they occupy in
the world economy. Seen from this vantage point, investors should by now already have very
significant allocations to emerging markets.
How is an investor to exploit the opportunities in emerging markets? Looking at figure 1 again,
the first answer that comes to mind is to buy an index.
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Risk Containment in Emerging Markets
The index approach
A pure index exposure to emerging markets equities would have been an extremely profitable
investment over the last 25 years and over the last decade in particular. Indexing is however not
a good strategy in emerging markets, as a number of familiar index problems are particularly
acute, including:
 Rather arbitrary benchmarks
 Fallacy of inclusion
 Fallacy of exclusion
 Overweight overvalued underweight undervalued assets
Whereas the index providers are doing a good job in providing yardsticks against which to
measure performance in emerging markets, the criteria used to select particular markets for
inclusion in either an emerging market (or frontier) benchmark would seem somewhat arbitrary.
The reduced liquidity and size of companies in these markets skews benchmarks when compared
to the actual productive capacity and other fundamental metrics of the universe. An indexing
investor will thus be particularly susceptible to the fallacy of inclusion (investing in an asset only
because it is in the benchmark), or the fallacy of exclusion (not investing in an asset because it
is not in the benchmark) and in general to having a portfolio that is overweight in overvalued
assets and underweight in undervalued assets.
In addition, there are a number of important risks that are not adequately addressed by the
benchmarks.
Risk factors in emerging markets
There are number of risk factors that need careful consideration when investing in emerging
markets. On the one hand, these risks present opportunities for the investor, as misperceptions
of their nature and magnitude can potentially lead to higher risk-adjusted returns. On the other
hand, they are risks and need to be treated as such.
Also, an investor needs to make clear whether he is a medium-to-long-term investor or not. Risk
can look very different from these two perspectives. In the case of longer-term investors, risk is
not about the ups and downs of stock market investment - without these there would be no
excess returns. Risk is about not getting a reasonable compounded return on your investment
through the entire holding period. In the case of shorter-term investors, risk might indeed be
identified with short-term volatility.
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Risk Containment in Emerging Markets
The most obvious risk factors are:
 Currency
 Liquidity
 Political
 Legal
 Regulatory
 Settlement
 Governance
 Corruption
 Natural
Currency risk is present not only in emerging markets but in developed markets as well. In fact
EUR/USD would often seem to be as volatile as EUR against a basket of emerging market
currencies. However, if need be, some local currencies can be hedged to Euro. This makes most
sense for fixed-income investments. For other asset classes and many - if not most – countries, it
is rational not to hedge as a substantial part of the return is probably going to come from
currency appreciation. This is particularly the case when emerging market countries are moving
from high-inflation regimes to controlled inflation, with concomitant high productivity growth
due to import of technology. Being able to identify countries and companies that are benefiting
from this (or at least not suffering too much from currency depreciations) is an integral part of
successful emerging markets investing.
It can sometimes take several months to assemble and years to liquidate significant positions in
small-cap companies in small emerging markets. So a clear understanding of the degree of
illiquidity is very important for the investor. And, in some cases, investments will have to be
approached with a private equity mind-set. If investors can assume the cost of illiquidity, there
are substantial excess returns to be picked up in emerging markets. That being said, there are
also plenty of investment cases to be made in the more liquid part of the emerging markets
universe.
Political, legal, regulatory and settlement risks are all related to the strength of institutions and
the rule of law in a country. The popular image that these all tend to be weak in emerging
markets is misguided. The courier cycling around in Kuala Lumpur, Malaysia with a briefcase full
of financial securities is a thing of the past. The major risk today would seem to be changes in
regulations whereby interpretation or enforcement of rules effectively gives the same result as
an increase in taxation. This, of course, will affect the market value of assets. Obviously these
risks can be larger in emerging than in developed markets. However, the importance is often
overstated. In most emerging market countries that would seem investable to the portfolio
investor – and there are in fact scores of them – very little money has been lost directly due to
these factors. It is rather changes in investors‟ perception of changes to these risks that lead to
market-induced losses (or gains).
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Risk Containment in Emerging Markets
An example of how fast investor perception can change is Brazil. As Luiz Inácio da Silva (aka
„Lula‟) stood to win his first election in 2002, the international investors fled Brazil in droves.
Instead, they should have paid attention to what he said (and to the fact that he was wearing a
jacket for the first time) during his campaign. The rest is history and Brazil is now among the
darlings of investors.
Bad corporate governance and corruption can be an issue in emerging markets, in particular in
countries whose experience with publicly-listed companies is limited – like many former socialist
countries. A dominant local shareholder might not have the term „minority rights‟ in his
vocabulary. For the largest and most liquid companies, this is usually not a major issue but an
investor would do well to perform due diligence prior to his investment, in order to avoid costly
mistakes. Corruption and fraud cannot always be detected; however use of reputable audit
companies and detailed checks on management will help a lot.
Even though many emerging markets are more prone to natural risks than developed markets the
uncorrelated nature of this risk makes it the perfect candidate to diversify away.
To sum up, emerging market risks are often misunderstood and overstated. However, judicious
evaluation of these risks can mitigate the downside on investments. And an investor that can
spot or forecast unrecognized improvements in these factors can earn substantial returns.
A value strategy adds value – also in emerging markets
With a lot of investor interest and flow of funds to emerging markets, the suspicion arises that at
least parts of the universe will be somewhat expensively priced. Some multiples are the same as
in developed world, so is expected profit growth high enough to justify this?
So we arrive at the most important risk factor:
 The risk of paying too much
An active approach to investment is more likely to reduce risks by avoiding bad investments and
to enhance returns by keeping an eye open for opportunities. This can be achieved by doing
fundamental analysis to understand business models. Active investing does not mean high
turnover – it simply means that the investor does not rely on markets to have priced in all
relevant information.
One way of doing this is through value investing: “The best foundation for a successful
investment … is value” (Marks, 2011).
The chart below shows that those investors whose emerging markets exposure has been achieved
through a value investment strategy would have obtained even higher returns than the market
average, and considerably higher returns than those adopting a growth strategy.
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Risk Containment in Emerging Markets
Empirical Evidence: Value Adds Value in Emerging Markets
Figure 3. Source: MSCI Emerging Markets Growth and Value Indices monthly returns Dec. 2000 – Jan. 2012
Indeed, the existence of a value premium in emerging markets has been identified and
calculated in academic studies. Rouwenhorst (1999) monitored 1705 companies across 20
emerging markets in the years 1982-1997. 16 of 20 markets showed outperformance of high
book-to-market (value) stocks, resulting in an average annual value premium of 9-12%,
depending on portfolio weighting. Other studies confirm this. Thus there is convincing evidence
that a value strategy has produced outperformance in emerging market investment.
But investors may wonder whether that outperformance has entailed unacceptable levels of risk.
This goes to the very heart of the long-term investment argument. Consider the annualized 5year returns distribution for a value strategy in emerging markets over the period Dec 2000 to
Jan 2012 (figure 4).
The great thing to notice here is that no matter when an investor first placed his money in
emerging market stocks, and no matter which strategy he adopted over this time period, the
mere fact of remaining invested for a continuous period of 5 years would have resulted in
positive returns. Thus investment success is not about timing but about time. If he had adopted
a value strategy, however, it would have paid off abundantly. Notice the way that returns from
the value strategy are positively skewed to the right, demonstrating an impressive „fat tail‟ of
higher returns.
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Risk Containment in Emerging Markets
Attractive Returns Distribution for Long-Term Investors
12%
Relative freq.
MSCI EM Growth EUR
MSCI EM Value EUR
10%
8%
6%
4%
2%
0%
-1%
2%
5%
8%
11% 14% 17% 20% 23% 26% 29% 32% 35% 29% 32% 35% 38% 41% 44%
Annualized 5-year returns
Figure 4. Source Sparinvest, based on MSCI Emerging Markets Growth and Value Indices monthly returns Dec. 2000 – Jan. 2012
Why opt for active management?
The performance of the MSCI Emerging Markets value index looks attractive, but, at its core, it is
still an index, basically an artificial construction dividing the entire MSCI World equity universe
in half. Thus, it is not addressing all the problems that have already been mentioned – especially
with regard to risk containment. To capture the value premium can take on average between
four to six years from the point of investment. Therefore, an active value investor reflects long
and hard on all the potential risks that might threaten shareholder value over the course of the
holding period. He must do this both at the outset and on an on-going basis.
Value investors are „bargain-hunters‟, and that word implies mispriced quality, not just low
prices. A company is therefore only considered „quality‟ if it has a robust business model, a
strong balance sheet and good earning potential with no hidden risks, including environmental,
social and governance (ESG) risks.
Such a bottom-up process that seeks out pure value may of course deliver a portfolio that
deviates considerably - in terms of geographical or sector allocation - from the MSCI Value
reference. The portfolio will however have better long-term risk / return characteristics.
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Risk Containment in Emerging Markets
Growth vs. lack of growth –
how value can work in both environments
What is important is that, whether emerging market growth has peaked or not, an active value
strategy still makes sense because it is not reliant on economic growth to succeed. In fact, as
markets become more mature, they can offer benefits that support an active value strategy
more effectively. As rule of law, accounting quality and overall corporate transparency improves,
the environment is much better for fundamental, bottom-up stock picking. What‟s more, as
conditions improve, it is likely that the sovereign ratings for these countries will improve - in
recognition of their attractive low debt to GDP. Upwards re-rating for sovereigns has a knock-on
effect on corporate bonds because it lifts the sovereign ceiling, reducing the risk premium built
into bond yields and justifying higher valuation multiples for equities.
Whether or not growth continues in the emerging markets, the main task of the active value
investor is to judge whether companies are deeply discounted to their intrinsic value. Of course,
in a high growth scenario, the intrinsic value will rise alongside the share price. But the value
discipline remains the same: once the share price is equal to intrinsic value, the margin of safety
in the stock has disappeared and it‟s time to sell. The only requirement for value investment to
work is that stock markets should continue to generate and correct pricing inefficiencies.
Conclusion
 Given their rise to economic power, emerging markets demand a substantial portfolio
allocation.
 Academic evidence concludes that a value approach works in emerging markets.
 The returns distribution of a value strategy shows that investors who ride out short-term
volatility are amply rewarded with excess long-term returns.
 To obtain purer value, it is best to work with an active and experienced value manager.
 A bottom-up stock selection screening process that is totally risk-focused, provides
important reassurance in a complex investment universe.
 Value investment works in growth and non-growth environments, making it a future-proof
strategy for emerging markets exposure.
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Risk Containment in Emerging Markets
References
Maddison, Angus – Website
Marks, Howard – The most important thing, Columbia University Press 2011
Mills, Greg – Why Africa is poor? Penguin Books, South Africa 2010
Ritter, Jay – Economic growth and equity returns, University of Florida - Department of Finance,
Insurance and Real Estate, November 1, 2004
Rouwenhorst, K G - Local return factors and turnover in emerging stock markets
The Journal of Finance, 1999 - Wiley Online Library
Vanguard, WP April 2010
Definition of Developed, Emerging and Frontier Markets
The MSCI World Index consists of the following 24 developed market country indices: Australia,
Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland,
Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden,
Switzerland, the United Kingdom, and the United States*.
The MSCI Emerging Markets Index consists 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*.
The MSCI Frontier Markets Index consists of the following 25 frontier market country indices:
Argentina, Bahrain, Bangladesh, Bulgaria, Croatia, Estonia, Jordan, Kenya, Kuwait, Lebanon,
Lithuania, Kazakhstan, Mauritius, Nigeria, Oman, Pakistan, Qatar, Romania, Serbia, Slovenia, Sri
Lanka, Tunisia, Ukraine, United Arab Emirates, and Vietnam*.
*As at May 2011
About Leif Hasager
Leif Hasager, Director of Emerging Markets at Sparinvest, is a Ph.D (Economics) University of
Copenhagen, where his specialist subject was socialist economies. His career of advising on
emerging markets within the financial services industry has spanned 25 years. Leif Hasager
travels extensively, spending around a substantial proportion of each year conducting first-hand
research into developing markets. He has visited the vast majority of MSCI-defined EM nations as
well as numerous „frontier‟ markets.
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