Last November, we wrote about why the 3-D’s—deficit, debt, and demographics—are leading to structural headwinds for most developed markets, including the United States. In that issue of Fundamentals we suggested that U.S. investors should move from a U.S.-centric worldview and consider a larger allocation to emerging market economies because they don’t face a 3-D Hurricane: with few exceptions, they have modest deficits, manageable net debts, and they’re not about to hit a wall of prospective retirees (apart from China, which hits the retiree wall a few years after we do). But any old salt can tell you that there’s still work to do even when sailing with the wind at your back.
Many investors may not have invested more in emerging markets in part because of the relatively poor long-term performance of emerging markets as measured by the traditional emerging market indexes. It is true that capitalization-weighted emerging market equity investors have been poorly compensated for bearing extraordinary risks. They’ve enjoyed no risk premium and no reward for helping these economies to emerge!
The Fundamental Index™ strategy, however, has historically delivered an excess return fully consistent with the spectacular economic and likely future economic success of the emerging markets. In this issue we delve deeper into why economic performance did not (seem to) translate into returns for emerging market equity investors. We also show how changing your frame of reference from capitalization weighting to economic size weighting changes the picture.
Say What? The Emerging Growth Miracle and an Excess Return of Negative 2%?!1
Unquestionably, emerging markets have undergone a tremendous transformation since the mid-1990s. Despite some fits and starts, these economies have nearly doubled relative to the developed world, going from 18% of the world’s GDP in 1994 to 31% by 2009 according to the International Monetary Fund, even as developed economies’ anemic growth drove them from 82% to 69% of world GDP.
But if you are talking about the stock market, sorry. Emerging market equities were far from impressive, posting a per annum gain of 6.4% from 1994 through 2009. This ranks 10th among the oft-cited 16 asset classes that form the core of our GTAA work and even trailed the S&P 500 Index (whose Lost Decade weighed heavily on this measurement period).2 Relative to the applicable short-term debt available in these countries, the story is even bleaker. The J.P. Morgan Emerging Local Markets Index, which measures the results of money market sovereign debt in the local currencies, returned 8.3% per annum. U.S.-based emerging markets cash investors got a whopping 200 bps of excess return above their stock markets, even as their economies soared!
Where’s the reward for funding the enterprises at the heart of the emerging markets growth miracle? For that matter, where’s the reward for enduring 27% annual volatility and 11 drawdowns of 15% or more in just 15 years?
How Did This Happen?
We believe the gap between emerging market economic and stock market performance is a direct result of the return drag from capitalization weighting. How so? Consider the composition of these stock markets. Often, one, two, or at most a handful of stocks dominate the local individual emerging markets. These stocks get much of the flows from foreign investors seeking a liquid manner to access the local market, usually with some degree of name brand recognition.3 These top dogs are the most beloved, the most liquid, the best connected, the best respected, and the most recognizable—particularly for global equity investors seeking a toe-in-the-water investment in emerging markets. They are also the most expensive. Their popularity translates into a very large market capitalization that often dominates their local exchange as seen in Figure 1.
If emerging markets are efficient (okay, quit laughing!), these large concentrated positions wouldn’t be much to worry about. Some may be overpriced and some may be underpriced but no more than the average stock, so performance would not be negatively impacted. To test this, we look at the subsequent performance of the top 10 holdings across the entire emerging markets universe by market capitalization. As Table 1 shows, the data confirm these popularity contest winners don’t grow to the sky—not once did they collectively outperform the rest of the market over a subsequent five-year period. Yet, that’s where the cap-weighted index puts most of your money! Talk about a stacked deck, those odds would make even the most greedy of casino pit bosses blush.
What’s it worth if we eliminate this return drag? Plenty! An emerging markets portfolio using the Fundamental Index methodology would have returned 16.2% per annum from 1994 through 2009, a nearly 1,000 bps premium to capitalization weighting. This simple switch in frame of reference shows the average company benefited handsomely during the rise of the emerging economies over the past 17 years. The average company outperformed local currency denominated money market securities by 7.9 percentage points, an excess return much more consistent with the stunning rise in emerging markets economies as seen in Figure 2.
An index built using economic weights performed brilliantly in a major economic growth period? Imagine that! It was capitalization weighting that produced the negative excess return for emerging markets investors.
What About Active Management?
The old efficiency argument—active managers can add more value in inefficient markets that suffer wider degrees of mispricings—has largely been the rule in emerging markets. Consequently, retail and institutional investors have typically filled emerging market mandates with active managers. The superiority of active management in this space seems to be on the wane now, however.
As Figure 3 illustrates, the use of the cap-weighted MSCI Emerging Markets Index has a clear upward trend versus active managers (measured using the Lipper Emerging Markets Mutual Fund peer group), migrating from roughly median to the top quintile. The Fundamental Index approach has performed even better, consistently ranking in the top 5% of the peer group over each three-year stretch. It doesn’t appear that active management is the mechanism to recoup the lost excess return in emerging markets!
When sailing the downwind leg of a race, experienced helmsmen will not sail in a straight line. They know their boats will be significantly faster by sailing at an angle, known as a broad reach. Of course, this point of sail requires zigzagging one’s way to the far marker. Counterintuitively, this back and forth is more efficient than a “set it and forget it” course straight downwind.
The S.S. G-7 is limping along into a stiff breeze and gathering seas. The headwinds are only increasing with the recent $1 trillion European bailout package this May. Untroubled by a 3-D Hurricane, the emerging market economies are headed in the opposite direction. But as we have shown, stunning economic success doesn’t necessarily translate into outsized market returns.
The sails still need to be tuned and the tiller still needs a steady hand. An economic super-trend deserves an economically weighted index, periodically rebalanced to stay on course. In so doing, we maximize our chances of rounding the buoy of investment success.
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1. We use the label “excess returns” to observe historical return differences. Some use the term risk premium, but we prefer the label “risk premium” to be used only in expressing expected future return differences.
2. The 16 asset classes are represented by the following benchmarks: ML US Corporate & Government 1–3 Year; LB US Aggregate Bond TR; LB US Treasury Long TR; LB US Long Credit TR; LB US Corporate High Yield TR; Credit Suisse Leveraged Loan; JPM EMBI + Composite TR; JPM ELMI + Composite; ML Convertible Bonds All Qualities; LB Global Inflation Linked US TIPS TR; FTSE NAREIT All REITs TR; DJ AIG Commodity TR; S&P 500 TR; MSCI Emerging Markets TR; MSCI EAFE TR; Russell 2000 TR. All indexes extend back to January 1994 except the LB TIPS.
3. Emerging markets tend to be a feast or famine flow asset class. Witness 2009 where emerging markets equity flows were +$75 billion, while developed market equity fund flows were a negative –$61 billion! (Source: EPFR Global.)