Download Challenges of Investing in Emerging Capital Markets: Integration vs. Segmentation

Challenges of Investing in
Emerging Capital Markets:
Integration vs. Segmentation
Paper presented by Global Investment House in the
Second Annual Palestinian Capital Market Forum
October 2008
Global Investment House
October 2008
Introduction
Emerging markets have gained increasing attention in the global investor community,
media, and academia in the last decade, so much that they have become a distinct
asset class altogether. To an extent, this attention is justified. Emerging economies
have been growing at roughly triple the rate of developed economies and currently
account for around half of total world GDP measured at purchasing-power parity.
This paper attempts to shed light on the characteristics of emerging markets with a
particular focus on emerging market equities. Aided by extensive academic
publications, the paper quantifies some of the unique features of emerging market
equities and compares and contrasts those with developed market equities.
The paper also addresses an issue that has come to the forefront of capital markets in
the second half of 2008: capital market integration versus segmentation. Specifically,
it takes an in-depth look at the prevailing trends in equity markets in the preliberalization stage and compares them to the prevailing trends in the postliberalization stage, citing specific country examples.
Finally, this paper attempts to apply some of the empirical work done on mainstream
emerging equity markets to MENA equities, by comparing selected parameters across
the Palestinian, Saudi and Egyptian equity markets. The results show that segmented
MENA equity markets, like Palestine and Saudi, have lagged integrated MENA
equity markets like Egypt, in terms of returns, but have experienced lower volatility
and exhibited significantly lower correlation with global equity markets in the last
decade. The paper concludes by recommending that fund managers overweight
integrated equity markets / underweight segmented equity markets when global
economic conditions are conducive, and do the opposite when the global economy is
creating an overhang on global equities.
I. Emerging Capital Markets: Definition & Classification
Up until now, no universally accepted definition of an emerging market exists, nor
does a consensus about which markets merit the “emerging” status. The composition
of the emerging market universe is in a continual state of flux. Today’s emerging
market may be tomorrow’s vibrant economy, thus, increasing the attractiveness and
importance of these markets.
In general, the term “emerging” implies the kind of growth and change that lead to
investment opportunities as a result of improved economic, social, and political
conditions. According to the World Bank, all countries classified as low or middle
income countries are categorized as emerging market economies. These are countries
with a 2007 gross national income (GNI) per capita of less than US$ 11,455.
According to this definition, 144 economies fall into the developing category,
however, only a handful of those countries merit the emerging title as the
classification by income does not necessarily reflect development status.
Standard & Poors (S&P) and the International Finance Corporate (IFC) define an
emerging market as a market in transition, growing in size (market capitalization),
activity (liquidity), or level of sophistication (modernizing and building market
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capacity). S&P/IFC classifies an equity market as “emerging” if it meets at least one
of the following two criteria:
¾ It is domiciled in a low or middle income economy as defined by the World Bank
¾ Its investable market capitalization (foreign portfolio open to foreign investors) is
lower than its recent gross national income figure
S&P/IFC added that equity markets which impose investment restrictions such as
foreign ownership limits, capital controls, extensive government interest in listed
stocks and other legal and political restrains on trading activity, particularly for
foreign investors, are generally considered emerging markets. S&P/IFC notes
“Pervasive restrictions on foreign portfolio investment should not exist in developed
stock markets, and their presence is a sign that the market is not yet “developed”.”
Moreover, Morgan Stanley Capital International (MSCI) developed a classification
framework spanning the spectrum of market types, from Frontier, to Emerging and
then to Developed Market. A new market accessible to international investors would
logically start as a Frontier Market and evolve over time, if and when warranted, to
Emerging Market status first and then to Developed Market status. In following this
path, a market would need to comply with increasingly stricter standards in terms of:
¾ Market accessibility (openness to foreign investment, investability, robustness and
efficiency of the operational framework).
¾ Company and security minimum size and liquidity, as well as minimum number
of companies and aggregate size of eligible securities.
¾ Sustainable characteristics of advanced economies and levels of geo-political risk
comparable to other existing Developed Markets, for achieving Developed Market
status.
MSCI Index Constituents
MSCI Emerging Markets Index
Argentina
Malaysia
Brazil
Mexico
Chile
Morocco
MSCI Frontier Markets
Bahrain
Romania
Bulgaria
Slovenia
Croatia
Sri Lanka
MSCI Arabian Markets
Bahrain
Egypt
Jordan
China
Colombia
Czech Republic
Egypt
Hungary
Pakistan
Peru
Philippines
Poland
Russia
Estonia
Kazakhstan
Kenya
Kuwait
Lebanon
Kuwait
Lebanon
Morocco
Oman
Qatar
India
Indonesia
Israel
Jordan
Korea
South Africa
Taiwan
Thailand
Turkey
Mauritius
Nigeria
Oman
Qatar
Tunisia
Ukraine
UAE
Vietnam
Saudi Arabia
Tunisia
UAE
Source: MSCI Barra
Currently, the above shown MSCI classification framework is the benchmark for the
fund management industry worldwide.
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II. The Case for Emerging Capital Markets
The percent of the world’s population, output and capital market represented by
emerging markets is steadily increasing. Emerging markets offer exciting growth
prospects and have in recent years shown signs of de-coupling from developed
economies. Although emerging markets are highly connected to the world in terms of
goods flow, they are not fully connected in terms of financial flows, reducing their
exposure to global turmoil and exogenous shocks.
The output of emerging economies is reaching an important milestone: it accounted
for around half of total world GDP measured at purchasing-power parity1. This means
that the rich countries no longer dominate the global economy and the developing
countries have a far greater influence on the performance of the rich economies than
history has shown. Emerging economies are driving global growth and having a big
impact on developed countries' inflation, interest rates, wages and profits. As these
newcomers become more integrated into the global economy and their incomes catch
up with the rich countries, they are expected to provide the biggest boost to the world
economy since the industrial revolution.
Population
GDP at market rates (US$bn)
GDP at PPP (US$bn)
Exports (US$bn)
Energy Consumption (mn toe)
Land Mass (sq. km)
FX Reserves (US$bn)
0%
10%
20%
30%
40%
Emerging Economies
50%
60%
70%
80%
90% 100%
Developed Economies
Source: Merril Lynch Estimates
The GDP of emerging market countries as a group has been growing at roughly triple
the rate of developed economies GDP in recent years. For example, in 2007, the real
GDP of emerging countries grew 7.9 percent compared to 2.7 percent for developed
countries. Growth in emerging and MENA markets is projected to be 6.7 percent and
6.2 percent for 2008, respectively, while developed markets are expected to witness a
major slowdown in the next couple of years. This lends support to the argument of
decoupling between developed and emerging economies.
1 Purchasing power parity (PPP) means that goods and services should cost the same in all countries
when measured in a common currency. It is the exchange rate that equates the price of a basket of
identical traded goods and services in two countries. Using a GDP at PPP basis is arguably more useful
as it takes into account the relative cost of living and the inflation rates of the countries.
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Real GDP Growth (%)
10%
8%
6%
4%
2%
0%
2003
2004
2005
2006
2007
Developed Markets
2008E
2009F
2010F
Emerging Markets
2011F
2012F
2013F
MENA Markets
Source: International Monetary Fund
Empirical evidence has shown a positive relationship between stock market
performance and economic growth2. It has been found that various measures of stock
market activity are positively correlated with measures of real economic growth
across countries, and that the association is particularly strong for developing
countries.
The importance of emerging capital markets is increasing relative to global capital
markets, as the share of emerging markets in world market capitalization has
increased from 9.35% at the end of 1997 to 19.3% in 2006. Moreover, the market
capitalization of emerging market countries has more than doubled over the past
decade, growing from less than $2 trillion in 1995; it is set to exceed $5 trillion in
2008.
Emerging Market’s Share of World Market Capitalization
9.35%
19.30%
90.65%
80.70%
1997
2006
Source: S&P Global Stock Markets Factbooks
2
Levine and Zervos (1998)
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III. Characteristics of Emerging Equity Market
Returns
Emerging markets are playing an increasingly important role in international
portfolios. A major argument for investing in emerging markets is their growth
prospects, high average returns, high volatility, and low correlations both across the
emerging markets and with developed markets.
Although emerging markets have exhibited higher volatility historically, they have
provided a significantly higher return over the last ten years. In fact, the MSCI
emerging markets index has outperformed the MSCI world index significantly,
posting a compounded annual growth rate of return of 12.73% versus 5.43% for the
world index over the last 10 years.
Value of $100 invested on Jan 1, 1998
350
300
250
200
150
100
50
1998
1999
2000
2001
2002
2003
MSCI Emerging Markets
2004
2005
2006
2007
2008
MSCI World
Source: Reuters
Volatility
As can be seen, the volatility of emerging markets is much higher than that of
developed markets. For example, during the past 10 years, the volatility (annualized
standard deviation) is 20.69% for the emerging index compared to 14.06% for the
world index. However, when comparing the expected returns to the amount of risk
undertaken, the results reveal that the emerging market stocks provided higher rates of
return than developed market stocks after adjustment for risk. Calculated using
monthly data, the reward-to-risk ratio of emerging markets stands at 0.62 relative to
0.39 for developed markets, showing significant outperformance on a risk adjusted
basis.
Emerging market returns depart from normality as the distribution of returns is not
symmetric, and the probability of a large price movement is higher than would be the
case if the distribution of returns were normal. Emerging market returns have more
positive skewness than developed market returns. Positive skewness means that there
are more frequent large positive returns than there are large negative returns. In other
words, large positive outlier returns occur more frequently than large negative outlier
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returns, indicating a bias to the upside. Similarly, emerging markets present more
excess kurtosis than the world benchmark. It is reasonable to expect that investors
prefer more positive skewness and excess kurtosis.
Positive Skew
Excess Kurtosis
The departures from normality imply that the usual mean-variance framework is no
longer adequate to characterize investment decisions. Hence, the standard deviation is
not a sufficient measure of market risk.
Investment risk in emerging economies often comes from the following sources:
a) Political Reform and Liberalization: some emerging countries do not have a fully
stable political and social situation, and the explosive social transformation
brought about by rapid, and sometimes anarchic, economic growth can lead to
serious imbalances, causing social and political unrest.
b) Infrastructure: infrastructure can limit growth; also education structures are often
insufficient to train a large number of workers and managers in modern
international techniques.
c) Corruption: Corruption is a rampant problem everywhere but may be more present
in some emerging countries. Family ownership tends to favor family and friends
at the detriment of other shareholders, especially foreign ones. Also links between
politicians and companies’ managers sometimes go beyond what would be in the
interest of shareholders.
d) The banking sector is sometimes poorly regulated, unsupervised, undercapitalized
for the lending risks assumed, and lacking in the sophistication required by
modern financial operations.
Correlation
Emerging markets exhibit a positive but moderate correlation with developed
markets; the correlation with the world index of developed markets is around 0.8.
Hence emerging markets can have a positive contribution in terms of risk-return
trade-offs.
Integrated markets have been found to exhibit relatively high correlation with global
equity markets. Our correlation matrix supports this notion, showing that MSCI BRIC
and Emerging indices are highly correlated with MSCI World, whereas MSCI
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Arabian index exhibits a much lower correlation with the World index. It is safe to
assume that BRIC countries are far more integrated than Arabian markets in the
global capital market.
MSCI
Arabian
Correlation Matrix
MSCI BRIC
MSCI
Emerging
MSCI Arabian
1.00
MSCI BRIC
0.38
1.00
MSCI Emerging
0.30
0.95
1.00
0.16
MSCI World
Correlations are based on 5 year monthly returns
0.78
0.83
MSCI World
1.00
International correlation tends to increase in periods of crises, and emerging markets
are subject to periodic large crises. Moreover, crises on emerging markets tend to be
more prolonged than crises on developed markets, and tend to spread to all emerging
markets in the region
Correlations between global equity markets have become more pronounced as global
capital markets are becoming more integrated and liberalization is becoming more
effective.
Correlations with MSCI World Index
1.00
0.80
0.60
0.40
0.20
2003
2004
2005
2006
2007
2008
(0.20)
MSCI Emerging
MSCI BRIC
MSCI Arabian
Correlations are based on 5 year monthly returns
Currency Risk:
The correlation between stock and currency returns is worth observing. Developed
markets sometimes exhibit a negative correlation with the value of their currencies;
the local stock market tends to appreciate when the value of the local currency
depreciates. The argument is based on an improvement in the international
competitiveness of the local firms, which is not the case for emerging stock markets
where both the stock market and the currency are affected by the state of the
economy. This positive correlation implies that foreign investors suffer doubly from
currency risk in emerging markets.
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IV. Challenges of Investing in Emerging Capital Markets
Investability of Emerging Markets
Many restrictions are imposed on foreign investors when it comes to investing in
emerging capital markets. Although many emerging countries are very liberal toward
foreign capital, investability is somewhat restricted in other countries. Restrictions can
take many forms:
a) Foreign ownership can be limited to a maximum percentage of the equity capital
of companies listed on the emerging market
b) Free float is often small because the local government is the primary owner of
many companies which leaves the float available to foreign or domestic private
investing limited
c) Repatriation of income or capital can be somewhat constrained (such capital flows
have been liberalized in most emerging countries, but controls are periodically
applied in periods of severe crisis)
d) Discriminatory taxes are sometimes applied to foreign investors, although this is
becoming exceptional
e) Foreign currency restrictions are sometimes applied
f) Authorized investors are the only investors allowed to invest in some emerging
countries, where these authorized foreign investors are typically institutional
investors as opposed to foreign retail investors
Providers of emerging market stock indices have tried to reflect the investability of
markets by constructing “investable” or “free float” indices, where foreign ownership
restrictions and free float strongly affect the weight of a given emerging country in the
index.
Market Illiquidity
Emerging markets are relatively illiquid and the transaction costs of investing in these
markets are sometimes significant relative to developed markets. Market liquidity
varies considerably across emerging markets as some markets exhibit liquidity levels
typical of developed markets, but most emerging markets exhibit substantially lower
liquidity levels. Since investors require higher returns in markets that experience
greater illiquidity, emerging market illiquidity premiums tend to be high and tend to
decline once the market is opened up to outside investors.
Information Inequities
Various aspects of this information asymmetry are:
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a) Insider Trading: information environment in emerging markets may deviate from
the assumptions of the semi-strong form of the Efficient Market Hypothesis
(EMH). For some classes of stock, material corporate news announcements are
generally associated with no change in stock prices. This behavior can be
explained by earlier insider trading by those who posses material nonpublic
information.
b) Domestic versus Foreign Information Advantage: local investors in emerging
markets naturally have an information advantage over foreigners. On the other
hand, foreign investors sometimes tend to outperform locals in their stock
selection and timing in emerging market investing
c) Financial Disclosure: a major reason for information inequities among investors in
emerging markets is arguably a lack of transparency of earnings disclosure
resulting from either poor accounting standards, perverse managerial motivations,
and/or lack of enforcement (e.g., credible auditing)
Under pressure from international investors, emerging markets are becoming more
efficient, providing more rigorous research on companies and progressively applying
stricter standards of market supervision. Accounting standards that conform with
International Accounting Standards (IAS) have been adopted in many countries and
are progressively implemented.
Risk and Return Measurements
The applicability of widely used financial models in emerging markets has long posed
a challenge in finance. Standard models are often ill suited to deal with the specific
circumstances arising in these markets. For instance, the Capital Asset Pricing Model
(CAPM) relies upon the assumption that investors have mean-variance preference
which in turn implicitly assumes that return distribution is symmetrical; however, as
previously mentioned, most of the returns in emerging markets have been found to be
non-normal.
Moreover, the CAPM is not an appropriate model if emerging markets are not
integrated into world capital markets. In integrated capital markets, assets with
identical risk should command identical expected returns, irrespective of domicile.
Provided that many of the emerging capital markets are not integrated into world
capital markets, the beta suggested by the CAPM may not be that useful in explaining
average expected returns.
Other problems most discussed in international corporate finance is the measurement
of an appropriate discount rate to use in evaluating investment projects in emerging
markets, which poses a significant challenge to multi-national companies and
investors of emerging markets.
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V. Integration versus Segmentation
Across the globe, capital markets are becoming more integrated, and this increasing
integration is particularly evident in emerging markets.
Segmented Markets:
A segmented market is a market in which there are impediments to the free flow of
capital and the expected returns on similar assets domiciled in different countries do
not exhibit a statistically significant correlation. Returns on local companies are
strongly influenced by domestic variables rather than global variables. Also domestic
risk in these assets is priced as opposed to global risk. The pricing of expected asset
return should be proportional to local risks, however, local volatility is much higher
than the contribution of the asset to the world market risk (its beta). Hence, expected
returns in segmented markets should also be higher. Segmented asset pricing tends to
be attractive to the global investor as it implies that assets are mispriced relative to
their international value.
Integrated Markets:
An integrated market is one in which there are no barriers to financial flows, and
assets with identical risk should command identical return, irrespective of their
domicile. Liberalization should bring about emerging market integration with the
global capital market. A liberalized equity market is that foreign investors can,
without restriction, purchase or sell domestic securities. The integration assumption
implies that risk in integrated emerging markets can be effectively defined as beta
with the world.
Transition from segmented to integrated state
The process of financial liberalization is time varying and not a one off event. This
creates difficulty in pin pointing the exact date of liberalization. In addition, removals
of regulatory restrictions may not attract foreign investments in the presence of other
indirect barriers and emerging market specific risks. These complexities cause
difficulties in the development of dynamic models for pricing securities in emerging
markets and measuring the impact of integration.
The implications for capital markets as they evolve from the segmented to the
integrated state are as follows:
a) Market prices may react upon announcement of liberalization or as soon as
investors anticipate it, and not necessarily upon the actual flow of foreign funds.
Historically, there has been a delay between the announcement of liberalization
and the authorization of actual foreign investment by governments. Hence, foreign
investors may not be able to enjoy the higher return experienced by local investors
because the capital begins flowing only after the ‘return to integration’ (the initial
price jump due to integration measures) has occurred and capital flows may see a
decline as a result (see diagram below).
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Source: Bekaert and Harvey (2003), Emerging Markets Finance, Journal of Empirical Finance, p.7
b) Higher degree of integration should reduce cost of equity capital (expected
return). The rationale is that the volatility of segmented market returns is much
higher than their covariance with world market returns. As markets integrate with
the world economy, the systematic risk becomes global. Holding other factors
constant, the implication is that as markets become more susceptible to global
sources of risk, the local variance decreases accompanied by increase in the
covariance with world market portfolio. Since the world market portfolio is
assumed to be less volatile than local market portfolio, this further reduces the
cost of capital and pushes up prices and valuation.
c) Some structural changes may be observed in the market. For example, companies
will be encouraged to go public as the cost of capital decreases, which will reduce
market concentration and increase depth.
d) Liberalization has been empirically associated with an increase in local market
liquidity
e) As individual stocks may become less sensitive to local information and more
sensitive to world events, cross-correlation of individual stocks within the market
may change.
f) Announcement or measures initiated to bring about integration do not necessarily
attract foreign investments due to legal barriers (e.g. foreign ownership
restrictions and taxes), indirect barriers (e.g. differences in available information,
accounting standards, and investor protection), and barriers arising from emerging
market specific risks (e.g. liquidity risk, political risk, economic policy risk, and
currency risk) that discourage foreign investments and lead to de facto
segmentation
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Effects of Market Integration
Bekaert and Harvey (2003) measured the impact of liberalization on 20 emerging
equity markets. Due to the complexity of the liberalization process, they define capital
market liberalization using three alternative measures: official regulatory
liberalization, the announcement of first American Depository Receipt (ADR) issue,
and the first country fund launching.
Tracing the impact of equity market liberalization on risk and return, they observed
the following:
¾ Returns: average returns decrease after financial liberalization.
¾ Volatility: There is no significant impact on volatility. On the one hand, markets
may become more efficient leading to higher volatility as prices quickly react to
material information. On the other hand, in pre-liberalized markets, there may be
larger swings from fundamental values leading to higher volatility, and as markets
integrate, gradual development and diversification of the market should lead to
lower volatility
¾ Correlation & Beta: correlation and beta with the world market increase after
equity market liberalization
Impact of Equity Market Liberalization on Returns
1.00
0.80
0.60
0.40
0.20
0.00
-0.20
Avg Annual Geometric
Returns
Avg Annualized Standard
Deviation
Pre
Correlation with World
Beta with World
Post
Source: Bekaert and Harvey (2003)
VI. Integration & Segmentation in a MENA Context
In this section, we attempt to capture some of the theoretical and empirical
underpinnings observed in global equity markets on MENA equity markets.
We compare volatility and correlations to global equities across the following
markets:
¾ The Saudi Stock Exchange: the Tadawul is our base case for a segmented MENA
equity capital market
¾ The Egyptian Exchange: the EGX is our base case for an integrated MENA equity
capital market
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¾ The Palestine Securities Exchange: the PSE is our extreme case segmented
MENA equity capital market
Given the lack of sufficient data on the above markets, it is difficult to conduct a pre
and post liberalization analysis of each market. Instead, we opt to compare segmented
MENA equity markets (Saudi and Palestine) with integrated MENA equity markets
(Egypt).
For Saudi, we believe the market remains a classic case for a segmented equity
market, despite recent developments that have opened the door for GCC investors and
more recently the initiation of equity swap agreements on specific stocks. Foreign,
non-GCC investors are still unable to directly access the Saudi market, and most do so
indirectly through investing in funds.
It is difficult to pin-point the exact date of liberalization for a stock market like
Egypt’s and hence we chose not to conduct a pre and post liberalization analysis.
However, we believe Egypt’s equity market is the most integrated of all MENA
markets, including Dubai where caps on foreign investments are still in place for
some stocks.
For Palestine, we acknowledge that the market is legally open to foreign investors, but
in effect the market in our opinion remains segmented as a result of political risk.
Our analysis has revealed the following:
Returns
All else equal, the net effect of foreigners has been very positive to equity markets in
our MENA sample over the last decade. Egyptian equities, our integrated example,
posted an annual growth rate of 29.9%, significantly outperforming Saudi and
Palestine which represent our segmented examples. Moreover, the Saudi equity
market slightly outperformed the Palestine equity market, and we partly attribute this
outperformance to stronger foreign investment in Saudi compared to Palestine in the
last decade.
However, the foreign investor effect has also been prevalent on the downside,
especially in 2008. The major re-rating in Egyptian equities in 2008 has been almost
exclusively led by net selling on the part of foreign funds and institutions, and was
exacerbated by retail investors who tend to be followers of foreign investors.
Palestine, being a segmented market, did not see a similar trend to Egypt, and the
year-to-date decline in Saudi equities has largely been caused by domestic factors.
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Value of $100 invested on January 1, 1999
2,000
1,800
1,600
1,400
CAGR (Egypt) 29.9%
CAGR (Saudi) 17.6%
CAGR (Palestine) 15.8%
1,200
1,000
800
600
400
200
0
1998
1999
2000
2001
2002
Palestine
2003
2004
2005
Saudi
2006
2007
2008
Egypt
Volatility
Our results show that Palestine is the most volatile market over the last ten years
compared to Egypt and Saudi. Egypt and Saudi support our conviction that segmented
markets (Saudi) are less vulnerable to exogenous shocks than are integrated markets
(Egypt). For Palestine, we believe that 10 year volatility is skewed by a one-off year
in 2005.
Overall, our results show that segmented MENA equity markets have exhibited lower
volatility than their integrated counterparts based on our three market sample.
Returns Volatility (10 years)
Palestine
Egypt
Saudi
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
40.00%
Annual Standard Deviation
70%
10 year volatility in Palestine is skewed by
a one-off year in 2005 when Al-Quds
index appreciated by 307%
60%
50%
40%
30%
20%
10%
0%
1999
2000
2001
Palestine
2002
2003
Saudi
15
2004
2005
2006
Egypt
2007
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Correlations with MSCI World
We examine correlations of returns of Saudi, Egyptian, and Palestinian equity indices
against the MSCI World index. Theory and empirical evidence applied to emerging
markets have shown that correlations with global equities increase post liberalization.
Our results are consistent with empirical evidence done on other emerging markets.
Based on 10 year monthly correlations, we find that correlations are significantly
higher in Egypt than they are with either Saudi or Palestine.
Correlations with MSCI World (1998 - 2008)
0.30
0.20
0.10
0.00
Al Quds Index
Saudi All Shares Index
CASE 30 Index
If we narrow down our correlation period to the last five years, we even find negative
correlations in Saudi and Palestine, and even more pronounced correlation in Egypt.
Correlations with MSCI World (2003 - 2008)
0.35
0.25
0.15
0.05
-0.05
Al Quds Index
Saudi All Shares Index
CASE 30 Index
Based on the results of our analysis, MENA-oriented fund managers may be inclined
to increase their allocation toward segmented equity markets and reduce allocation
toward integrated equity markets when they expect exogenous shocks to the global
financial system to increase. Year-to-date, this strategy would have held correctly in
Palestine (overweight – YTD = +25.2%) and Egypt (underweight YTD = -29.7%).
However, in Saudi, we believe local market factors have dominated on the downside
(overweight YTD = -34.6%).
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Conclusion
The attention given to emerging markets in the last decade is warranted and their
categorization as a distinct asset class may be appropriate. After all, emerging equities
have been shown to exhibit an entirely different risk-return profile relative to
developed equities, and bring to the table a host of unique characteristics including
information asymmetry, liquidity constraints, varying corporate governance standards,
etc.
Historical results point to a significant difference in equity returns, volatility,
correlations, and world beta in the pre and post capital market liberalization stages.
Most notably, average returns have been found to decrease after financial
liberalization, correlation and beta with the world market increase after equity market
liberalization, and the net impact on volatility not significant.
In a MENA context, our analysis and results were more or less consistent with
observations seen in other emerging markets. The net effect of foreigners has been
very positive to our integrated equity market (Egypt) in our MENA sample over the
last decade in terms of equity market returns. Volatility was higher in our integrated
MENA equity market compared to our segmented MENA equity market, with the
exception of Palestine which we argued was affected by 2005. Finally, correlations
with global equities were far more pronounced in Egypt than they were in Saudi and
Palestine.
Our results put forth a strong case for fund managers to underweight integrated /
overweight segmented MENA equity markets when global equity markets are in
turmoil, and take an opposite position when conditions are conducive to global
equities.
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References
Bekaert, Geert, and Campbell R. Harvey, 2003, “Emerging Markets Finance,”
Journal of Empirical Finance, Vol. 10, nos. 1-2, pp. 3-56
Bekaert, Geert, Campbell R. Harvey, and Robin L. Lumsdaine, 2002, “Dating the
Integration of World Equity Markets,” Journal of Financial Economics, Vol.65, no. 2,
pp. 203 - 247
Bekaert, Geert, Claude B. Erb, Campbell R. Harvey, and Tadas E. Viskanta, 1998,
“Distributional Characteristics of Emerging Markets Returns and Asset Allocation,”
Journal of Portfolio Management, Vol. 24, pp. 102-116
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