Point of View

Many institutional investors seem to view emerging markets stocks as fashion trends. But such an attitude has led the majority of institutional investors to underweight one of the better performing asset classes in countries that are accomplishing major – and very likely permanent – economic improvement. Demographic advantages provide additional long-term support for emerging markets.

High commodity prices have undoubtedly been a critical factor contributing to the outperformance of emerging markets over developed markets for the past five years. However, government debt reduction, deregulation and improved trade terms in many of the most important emerging economies have all helped diminish inflation, build up foreign currency reserves and contribute to a prolonged wave of prosperity.

“The result has been productivity gains and economic growth in low-interest-rate, low-inflation environments,” says Steven A. Schoenfeld, chief investment strategist for Northern Trust’s global quantitative management group. “In 2006, GDP growth in emerging markets is expected to be between 5.5% and 5.9% – substantially higher than developed markets.”

Today, many emerging market companies are industry leaders and global market players. Korea’s Samsung has twice the market capitalization of Japan’s Sony, for example. Brazil’s Embraer is the world’s third-largest commercial aviation firm and India’s Infosys has dominated the outsourcing revolution.

“These blue-chip firms produce high-value products at a low cost,” Schoenfeld says. And in that, they’re not alone: Market capitalization of emerging market countries has more than doubled over the past decade. At more than 12% of the non-U.S. equity world, this means emerging markets have become simply too big to ignore.

Pension funds and other institutional investors poured some $14 billion into emerging markets in 2005. That’s up 40% from the year before, according to an International Monetary Fund report.

Yet they’re not always an investment priority. For instance, the majority of U.S. institutional investors still allocate most of their portfolios to domestic stocks. “As emerging markets represent fully 45% of world GDP and 84% of the world population, the need exists for investors to maximize the opportunity to profit from this growth,” Schoenfeld adds.

Pension funds and other institutional investors poured some $14 billion into emerging markets in 2005. That’s up 40% from the year before.

“Of the 26 countries in the MSCI Emerging Markets Index, all but a handful now allow easy access for foreign investors,” says Jim Francis, head of emerging markets in Northern Trust’s global quantitative management group. “Many of these countries now feature fully automated trade and settlement mechanisms,” he says. “These improved trading systems allow for much better analysis and execution in these markets. And a longer history of securities prices provides more reliable collection of risk data.” All of these factors can make it easier than ever to construct an efficient portfolio of emerging market firms.

Investors have responded enthusiastically to these developments. The MSCI Emerging Markets Index gained 30% in 2005, outperforming the U.S. and other developed markets for a fifth straight year.

“The Index has continued to outperform other asset classes so far in 2006,” Schoenfeld says. “While the pace of growth may be unsustainable, especially as interest rates within emerging market countries increase, many emerging market firms still boast compelling valuations.”

In addition, correlations with the S&P 500 Index, at 0.73 on a three-year rolling basis, as of January 2006, mean that “the long-term benefits of adding these equities to the portfolio are clear from diversification potential as well as from a growth standpoint,” Schoenfeld adds.

Overcoming Home-Country Bias

Emerging markets have increasingly gained acceptance among institutional investors, with allocations now at $93 billion, as reported by InterSec. Yet emerging markets are still underweighted in institutional portfolios – that $93 billion represents just 1.5% of the total institutional investment of more than $6.2 trillion. And yet, at the end of the first quarter of 2006, emerging markets represented 7.5% of world capitalization as measured by the MSCI All Country World Index as of March 31.

“The underweighting of emerging markets is symptomatic of the broader problem of a home-country bias among institutional investors,” Francis says. “But to better understand why these stocks in particular are underweighted, we should look at how some plans currently achieve exposure to emerging markets.”

In a typical scenario, a plan will hire an active manager to oversee its international strategy, Francis says. This manager is benchmarked to the MSCI EAFE Index, which covers all developed markets. The manager’s investment guidelines, however, will allow him to buy a certain percentage of securities outside of the Index.

“Frequently these purchases have been in emerging markets,” Francis says. “The manager holds just a few emerging market companies, not enough for a sufficient allocation in this class and certainly not enough to allow for diversification within the class. And, frequently, it is this �dabbling’ that accounts for the manager’s outperforming the benchmark.”

This isn’t an optimal situation, Francis says. “We believe a better approach is to invest in a well-constructed emerging markets index fund, where plans can often match or even exceed the returns that had previously been attributed to the active manager’s hand – and at a lower cost.”

Conventional wisdom holds that active managers should be able to exploit the inefficiencies in emerging markets. But in reality, Schoenfeld maintains, these markets are actually becoming more efficient and represented more accurately as benchmark methodology evolves.

“Because of better information flow from emerging markets, index vendors have better information on share availability,” he says. “Thanks to the move to float adjustment, these indexes can be more accurately weighted for a better picture of the market. As a result, turnover and associated costs are minimized.”

As always, costs and fees also erode the active manager’s alpha. Despite their improved efficiency, emerging markets still sport the highest transaction costs of any class due to higher commissions and wider spreads. Emerging market transaction costs average 1.08%, and a dozen countries have costs higher than 1.5%. “Once you add in active management fees – typically three times higher than passive fees – you have a performance handicap for active managers to overcome,” Schoenfeld says.

Country Performance Drives Returns

Active managers may hop around the globe eyeing Indonesian palm oil plantations or Venezuelan oil rigs in the hope of building a global hot-stock portfolio.

But the data show that for emerging markets, country performance is by far the biggest driver of returns – far exceeding sector performance.

“In any given year, the worst stocks in the best-performing countries tend to outperform the best stocks in the worst performers,” Schoenfeld says. “Country performance can be highly variable. For example, according to the S&P/IFC Investable Index, Turkey and Venezuela have swung between the top- and bottom-performer lists within the last few years. But the challenge of picking winners merely points up the need for comprehensive exposure to the class.”

This doesn’t mean it is impossible to outperform the benchmark. “But doing so is dependent on finding the right active manager, and that can be a daunting challenge,” Schoenfeld says.

“Fewer than half of current emerging markets managers have a 10-year performance history. Those with the most stellar records are facing serious capacity constraints as the popularity of the emerging market class increases. Achieving a policy allocation for emerging markets based solely on active management is a difficult task.”

Structuring an Emerging Markets Allocation

When it comes to emerging markets, investing in an active or passive strategy does not need to be an either/or proposition.

“In domestic allocations, plan sponsors have become more sophisticated in their strategies, combining index, enhanced index and traditional active management to more efficiently achieve targeted rates of return,” Schoenfeld says. “There is no reason not to apply these principles to international and emerging market equities as well.” (See “The Search for Efficient Asset Class Exposure,” page 13, for more information on using combined strategies for achieving targeted rates of return.)

“For emerging markets, index funds can be an ideal core investment strategy,” Schoenfeld says. “They represent an efficient, cost-effective way to achieve asset and style diversification. They help eliminate the danger of style drift. And they assure exposure to this class while the investor searches for active managers with the potential to add alpha.”

At the country level, success still requires the understanding of particular regulatory and investability issues. But these markets are evolving rapidly. At one end of the spectrum, countries such as Korea and Israel feature mature stock markets and blue-chip-level firms. At the other end, fast-growing countries in regions, such as Eastern Europe and the Middle East, are on the cusp of joining the class. And new share classes will offer ways to buy into emerging economies like China.

Schoenfeld maintains, “Comprehensive exposure to emerging markets – and to international equities as a whole – is an ideal way to take advantage of the opportunities to come.”

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