Emerging Markets Equity

Updated February, 2006

As an asset class, emerging markets equities offers the potential for higher returns than foreign (developed market) equities, though at the price of higher risk. The higher return potential is driven by rates of both labor force and productivity growth that are higher (sometimes considerably so) than comparable rates in more developed countries. On the other hand, emerging markets also tend to have (and these are broad generalizations), less stable political systems and economies than developed markets. Consequently, the returns on emerging markets equity investments are more volatile than those on developed markets equities.

The following table quantifies these points. Unlike other tables in this article, it is based on a shorter data series, as high quality information on emerging markets equity returns only became available in 1988.

Emerging Markets Equities, 1988-2002

	Arithmetic Average Annual Return	Standard Deviation	Skewness	Kurtosis	Correlation with Foreign Equity Returns	Correlation with Domestic Equity Returns	Spread over Domestic Equity Return
A$	13.7%	25.3%	(.05)	1.76	.41	.63	6.6%
C$	11.5%	22.8%	(.52)	1.33	.57	.53	4.2%
DM/Euro	12.4%	27.7%	(.38)	.64	.73	.64	5.9%
Yen	12.6%	26.6%	(.39)	.84	.71	.38	15.0%
GB £	10.8%	27.0%	(.38)	1.11	.73	.56	4.9%
US $	9.6%	24.0%	(.58)	1.53	.55	.62	0.6%

As you can see, emerging markets equities have produced quite impressive returns over the past fifteen years, as these countries received substantial inflows of capital and gradually opened their doors to foreign portfolio investors (i.e., individuals and institutions wishing to buy shares or bonds issued by companies located in these markets). Unfortunately, this period also saw a number of debt, inflation, and foreign exchange crises in these markets, which gave rise to the relatively high levels of volatility experienced by foreign investors.

An interesting question is the extent to which these historical returns will be repeated in the future. To examine that question, we looked at the current dividend yields and forecast rates of GDP growth (from the IMF) for fifteen of the largest (by market capitalization) emerging equity markets. The following table shows the estimated future equity returns for these markets:

Estimated Future Real Annual Returns in Emerging Equity Markets

	Dividend Yield June, 2003	99-04 Growth (IMF Estimate)	Estimated Future Equity Return
Brazil	4.80%	2.71%	7.51%
Mexico	1.90%	2.61%	4.51%
Chile	1.80%	3.41%	5.21%
China	3.20%	7.66%	10.86%
India	2.50%	5.10%	7.60%
Indonesia	3.90%	3.90%	7.80%
S.Korea	1.80%	5.72%	7.52%
Malaysia	2.50%	4.71%	7.21%
Taiwan	1.80%	2.78%	7.58%
Thailand	2.80%	4.03%	6.83%
S.Africa	4.30%	3.06%	7.36%
Isreal	1.70%	1.59%	3.29%
Russia	2.00%	5.14%	7.14%
Poland	2.60%	2.59%	5.19%
Hungary	1.50%	3.96%	5.46%

The weighted average expected future equity return for all fifteen countries is 6.33%. This is higher than the future estimated return for most developed country markets, but certainly not by that much. And it is well below the real rates of return emerging markets equities have delivered in the past. As we have seen before, the underlying culprit is low starting dividend yields in many countries, which reflects the result of the inflows of foreign capital (and upward pressure on their equity prices) that many of these countries have experienced in recent years.

If the relative riskiness of these countries has not also declined, then the argument for investing in them as a single asset class has also weakened. Is there any basis for believing that the relative riskiness of investing in emerging markets has also fallen? On the global level, there is an argument that the world has become more, not less risky, with rising probabilities for periods of both deflation and inflation. Moreover, growth in many of these emerging markets is heavily dependent on exports to developed markets -- if the latter suffer, so do the former. Finally, the political institutions in many of these emerging markets are still underdeveloped relative to those in developed market countries. When growth slows in these economies, governments are less able to resist popular pressure for measures that may reduce the returns earned by foreign investors (e.g., inflationary spending, exchange controls, debt defaults, etc.).

On the other hand, the experience gained through managing the many crises that occurred during the past thirty years has probably made the system better able to weather the ones we will confront in the future. On balance, however, we think that these factors are at best offsetting, and that the overall riskiness of investing in emerging markets equities hasn't decreased. Given this, going forward emerging markets equities as an asset class (given their current expected future returns) seem less attractive today than they have in the past. Within the asset class, however, there are still some regions (notably Asia), where expected risk-adjusted returns seem high enough to justify some investment.

Finally, in terms of exchange rate effects, many, but not all of the emerging markets countries have linked their currencies to the U.S. dollar. In the case of other asset classes, we have used the expected exchange rate changes implicit in today's government bond rates to adjust expected real returns. However, we have decided not to do this in the case of emerging markets equities, because the future existence of these "dollar pegs" seem highly uncertain, given our current economic outlook.

Given this, in our model portfolio analysis, we will use 7.50% (approximately the average expected return for emerging Asian markets) as our future return assumption for emerging markets equities, along with the historical standard deviations from the 1971-2002 period.

So, to sum up the arguments in favor and against investing in the emerging market equity asset class:

Market Condition

Normal

Inflation

Deflation

Reasons to Invest in Emerging Market Equity

May deliver higher returns due to exposure to a wider range of opportunities

Should deliver some risk reduction benefits

Since equity is a claim on residual cash flow, and since companies can eventually adjust their prices when faced with inflation, equity returns should suffer less than fixed rate bond returns

Some companies, e.g., consumer staples providers with strong brands/pricing power and low debt levels, could do very well during deflation. However, the returns for the asset class as a whole will suffer during deflation.

Reasons Not to Invest in Emerging Market Equity

Future returns may not be as high as historical returns, while volatility remains at close to its historical level. In short, the risk/return trade-off for the asset class as a whole may have worsened (though this may not be true for some subregions, such as developing Asian countries).

Other asset classes (e.g., real return bonds, commodities, and residential property) provide better protection against inflation

Other asset classes – such as investment grade bonds – provide better protection against deflation.