New Engines of Global Growth

Last year, China displaced Japan as the world’s second largest economy, underscoring why it and fellow BRIC countries –– Brazil, Russia and India –– are key building blocks of a global investment portfolio. Tapping into global economic growth and finding fertile investing opportunities, however, will involve more than merely building with BRICs.

New research by the McKinsey Global Institute forecasts a world where megacities and developed economies will have diminished impact on global economic growth during the next 15 years. In their place will be midsize cities in emerging markets, with current populations of 150,000 to 10 million. Although megacities and developed economies accounted for 73% of global economic output in 2007, their contribution is expected to fall to 34% of economic growth through 2025. In contrast, the midsize cities in emerging markets, which accounted for 11% of economic output in 2007, are expected to increase their contribution to 37% between 2007 and 2025. The report also highlights the expectation that top-performing middleweight cities such as Lagos, Nigeria; Jakarta, Indonesia; and Colombo, Sri Lanka, will outperform megacities in terms of household growth.

For institutional investors, this shift of the global economic drivers serves as a powerful reminder of the importance of looking outside your home country and beyond the better-known BRICs to smaller emerging and frontier market countries for investment opportunities.

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Completing the Picture

While most investors take a complete approach to their U.S. exposure, including large‑, mid‑ and small-cap stocks, many have yet to complete their international exposure in a similar manner. This results in pockets of missed opportunities and a lack of full diversification. Traditionally, investors have used the MSCI World ex-U.S. or the MSCI EAFE as their proxy for international investing. But that misses a large portion of the opportunity set by focusing on large- and mid-cap securities in developed economies.

“While investors have added emerging market exposure in recent years to further diversify their portfolio and capture the growth potential in these markets, we still find that many investors tend to be underweight relative to market cap in emerging markets, with 5% or less exposure on average,” says Chad Rakvin, director of global equity index management at Northern Trust, Chicago. “They tend to remain focused on the larger-cap securities within emerging markets and they neglect small-cap emerging and frontier market stocks.”

“We’ve been talking to clients for some time about the importance of reducing home-country bias,” Rakvin says. “For example, it’s not unusual for U.S. investors to have 60% or 70% or more of their stock portfolio allocated to U.S. stocks, but the U.S. stock market makes up only 43% of global market capitalization.”

One danger of being too home-market centric is the potentially lost opportunity to gain exposure to diversified markets that have high growth potential as well as low correlations with other portfolio components. For example, for the decade ended in December 2010, while the S&P 500 Stock Index had a 0.82 correlation with the MSCI Emerging Markets Index, it had a lower correlation of 0.76 with the MSCI Emerging Markets Small-Cap Index and an even lower 0.60 correlation with the S&P BMI Frontier Markets Index.

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Beyond the BRIC Countries

In recent years, the BRIC countries have received — and have largely deserved — a great deal of attention. China’s economy continues to soar at a growth rate of around 10% per year. Calculated as a group, the BRIC countries’ average annual GDP growth rate was 8.3% for the years 2006 through 2009, compared with 0.65% for advanced economies during that same period. Despite these emerging giants’ impressive track record and ongoing strength, robust economic growth is no guarantee of strong stock market returns, especially when growth is not accompanied by sound fiscal policies. In addition, plenty of growth potential lies beyond the BRICs, along with the opportunity for more efficient risk-adjusted returns.

“I think it’s important to take a step back and look at how emerging markets fit in the context of the international equity opportunity set,” says Greg Behar, senior investment strategist, global index management group at Northern Trust, Chicago. “You’ll see a BRIC-only strategy doesn’t provide sufficient exposure.”

Behar points out that a concentration on just the BRIC countries provides exposure to four economically significant emerging market countries, but it increases one’s country-specific risk. And because the BRICs are highly correlated to each other, it magnifies a portfolio’s overall volatility. A BRIC-only approach represents just 300 securities while ignoring the other 17 emerging market countries and more than 1,400 securities. On top of that, it ignores 30-plus frontier market countries that are projected to have strong growth and historically have offered diversification benefits.

Another reason why diversification into smaller-cap and emerging markets stocks is effective in adding depth and breadth to a global investment portfolio is that smaller companies tend to do more of their business locally. Consequently, they are driven by factors that are primarily local, rather than global, in nature.

“The larger companies within the BRIC countries, such as Petrobras or Gazprom, are affected more by global events,” Behar notes. “In contrast, emerging market small-caps and frontier market companies are driven more by local and regional factors. For instance, a Nigerian brewery or Kuwaiti telecom company is going to be driven by demand in those regions.”

There are also long-term, secular trends to consider. For example, emerging markets made up 1% of global market capitalization in 1988, but after two decades of strong growth they now represent 14%. The next large economic growth engine could be frontier markets, which resemble emerging markets 20 years ago, making up less than 1% of global market capitalization today. “Frontier markets have relatively lower liquidity and higher transaction costs, but have higher economic growth projections than developed and more mature emerging markets. Even with strong historical and predicted economic growth, frontier market economies remain underweighted relative to developed and more advanced emerging market countries,” Behar says.

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Overcoming the Investment Challenges

One concern among institutional investors is the difficulty of tracking a benchmark that has significantly higher transaction costs relative to developed markets. “Although commissions are generally higher in emerging markets, they have come down significantly over the years,” says Shaun Murphy, senior portfolio manager, global index management group at Northern Trust, Chicago. “It’s important that index managers look beyond just minimizing explicit costs, such as commissions, and also consider implicit costs, such as bid-ask spread, market impact and opportunity costs,” he adds.

Murphy notes that in both the portfolio construction and trading phase of the process, the main goal is to maximize liquidity and avoid wealth erosion. “The ability of any index manager to find the optimal trade-off between minimizing transaction costs and active risk will show up in the relative performance of a fund compared to both the index and to peers.”

Despite recent progress, emerging markets still have significant risks. There are additional transaction costs as well as heightened operational, regulatory and geopolitical risks relative to developed markets. “Clearly, understanding the risks and ensuring procedures are put in place to mitigate them is a key part of managing emerging market assets,” explains Murphy. Although index vendors use liquidity and investibility screens, the real-world challenges have to be understood and managed. “There are steps a portfolio manager can take to ensure the operational and market risks are reduced and the liquidity of the portfolio reflects the activity that can occur,” Murphy says.

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Always Delve Deeper

By maintaining a broad-based exposure to all corners of the market, investors can help keep their portfolios well positioned to capture future investment opportunities. “Being there and having diversified exposure is most important,” Behar says. “An index fund can provide diversified exposure quickly, efficiently and at a lower cost.”

By moving beyond their home market, the more developed global economies and the well-publicized BRIC countries, institutional investors will have a more diversified global portfolio and the potential exposure to the new engines of global growth.

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