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Financial Happenings Blog
Wednesday, October 07 2009

Indonesia has a special place in my extended family and my life.  i therefore am very interested in the plight of their economy and their share market.  Indonesia is a part of what the investing world will define as Emerging Markets.  The exact description of this term will differ from investment house to house but for economists it is generally speaking the "developing" economies of the world including Asia (ex Japan), South America, Eastern Europe and Africa.

A lot of analysis over the past year has focussed on how these economies have fared better and might be the key to a strong global economy into the future.  No surprises then to see Emerging Market indices rise much stronger and faster compared to the more developed (rich) economies.  Indonesia for instance has risen 123% for the year to date to the end of September as measured by Standard & Poors.  Their Emerging Markets Index has risen 64.5%.  Developed World markets have risen less so - 25.3% according to S&P (All in US dollar terms).

Most investment analysts would suggest their clients have some exposure to Emerging Markets, as does our firm, however the question becomes how to get that exposure?

A recent article written by Dimensional's Jim Parker provides an insight into how Dimensional Fund Advisors see this decision with particular reference to China.  The full text is repeated below:

October 2009
Chinese Walls

Investors confronted by the recent less than stellar performance of the US economy, traditionally the world's powerhouse, are being urged to increase their exposure to China and other emerging markets. But how?

A traditional response to that question is that the best way of "buying the China story" is to re-weight one's global portfolio away from the developed economies of North America and Europe to high-growth Asia.

It sounds like a tempting strategy, particularly given the change in focus in global policy-making away from the Group of Eight rich western economies to the Group of 20 that also embraces China and other emerging economies.

Rightly or wrongly, the origins of the global financial crisis in the US and Europe are seen as shifting the balance of world economic power, a tilt that was evident recently as G20 leaders gathered in Pittsburgh.

The so-called 'BRIC' emerging economies ? Brazil, Russia, India and China ? were among those leading calls at the G20 summit for what they perceive as the need for a fairer and more inclusive set of global economic structures.

Partly in response to this apparent rebalancing of economic power, much of the investment industry is aggressively marketing strategies that seek to provide investors with greater exposure to the BRIC powerhouses.

So how should individual investors respond to this pitch?

Firstly, it is certainly true that emerging markets can play an important role in a portfolio. They provide great benefits in terms of diversification and offer higher expected returns than developed markets as compensation for the higher degree of risk of investing in emerging markets.

But investors should also keep in mind that the size of the market opportunity is not necessarily the same as the size of the economic opportunity.

The table below, from the World Bank1, ranks the top 20 countries of the world by gross domestic product and adjusted for purchasing power parities. This is a way of taking account of the relative prices of goods and services in each country and provides a better measure of the real value of output.

As you can see, the BRIC economies are well represented in this list, taking up the second, fourth, sixth and ninth positions on the table. Australia is relatively low in this ranking, in 18th position between Iran and Poland.

Now, take a look at the country weights of the MSCI World All Countries Investable Market index2. This takes into account the actual opportunities in these countries for global investors, after adjusting for local market restrictions on foreign share ownership.

In this list, China is in ninth position with a weighting of just over 2 per cent of global market capitalisation, Brazil is in 11th place, India is in 18th position and Russia is at the bottom of this abbreviated list.

Australia ranks at number six in terms of market capitalisation, just below Canada and ahead of Germany. And the US, as well as the biggest economy, is also the most heavily weighted market, with a country weight of a little more than 40 per cent.

What this tells us is that in developing economies, the real economy tends to mature faster than the financial market that supports it. Weighting an investment strategy around the gross domestic product of each country will tend to result in an overweight towards emerging markets. Of course, this may be a legitimate choice for some people, but bear in mind it would also be a riskier strategy.

The second consideration is that emerging markets should be treated not as an alternative to developed markets but as a distinct asset class. While they offer higher expected returns, they often also tend to be more volatile. These distinct risk-return characteristics mean they require careful management.

As an investment manager, Dimensional considers a number of practical issues when deciding whether to enter a particular emerging market. These include the particular country's respect for property rights; its fair treatment of foreign investors; quantitative measures such as liquidity, market cap and stock concentration; agency risk and trading mechanisms.3

Even when a country meets strict criteria around these specific issues, there are still risks for investors in having too much exposure to a single market. Dimensional deals with this by weighting countries by market cap, but with a buy cap of 12.5 per cent for any one country.

In some cases, when foreign participation in a local equity market is severely restricted, Dimensional will seek exposure to the companies of that market through their listings in more developed markets via depositary receipts and other alternative vehicles. For instance, it accesses the returns of Chinese companies by buying their 'H' shares listed on the Hong Kong market.

Against that background, it seems clear that building an emerging markets strategy around just the BRIC economies means taking on diversifiable risk. Apart from the fact that they are big and they are growing rapidly, these four economies have little in common. Brazil and Russia, for instance, are commodity producers, while India and China are commodity importers.

Another consideration for investors is that getting greater exposure to say the Chinese or Indian growth stories can be achieved in ways other than investing only in Chinese or Indian companies.

BHP Billiton, for instance, is the world's largest mining company and the biggest company on the Australian market. With its voracious appetite for raw commodities, China represented 20 per cent of BHP's global revenues4 in fiscal 2009, with India also an increasingly significant contributor. Obviously, then, owning BHP stock provides indirect exposure to those economies.

BHP's experience is true for the Australian economy more broadly. According to the Reserve Bank of Australia, 23 per cent of Australia's total exports went to China in the June quarter of 2009, up from about 4 per cent a decade ago.5

Australia's close linkages with China, through commodity exports, partly explain its extraordinary resilience throughout the recession that has hit developed economies in the past year. So an Australian investor who bemoans his lack of exposure to China needs to look first in his own backyard. He has a degree of exposure just by investing locally!

And this is not just true for Australia. In the US market, an increasing proportion of the sales of listed American companies are sourced offshore. Indeed, Standard & Poor's estimates6 that of the reporting companies in the S&P 500, just under 48 per cent of all sales last year were produced and sold outside of the US, up from 45.8 per cent in 2007 and 43.6 per cent in 2006.

Among the major US multi-nationals, Alcoa and Motorola earned significant sales in Brazil, while Citigroup and Intel had a big exposure to the Asian economies, according to the S&P data analysis.

This means that investing a significant proportion of one's global assets in the United States equity market does not necessarily equate to taking a taking a similar sized bet on the US economy. The US market plays host both to American multi-national corporations with significant overseas revenues and to leading companies from economies around the world ? both developed and emerging ? that are seeking to tap the most liquid market on the planet.

So in summary, it is true that emerging market economies are representing an increasing share of world economic output and that the investment returns of companies in these markets deserve a place in a diversified portfolio.

But in assessing their exposure to emerging markets, investors need to distinguish between the economic opportunity and the market opportunity.

While countries like Brazil, Russia, India and China take up a greater share of world GDP, their listed equity markets are relatively undeveloped and still represent a relatively small slice of global market capitalisation. Basing an investment strategy purely on size of each country's economic output may be a legitimate choice, but it is a riskier one.

What is more, emerging markets have different characteristics to developed markets and should be seen as a separate asset class. While they offer higher expected returns, they also are more volatile. The best approach to this asset class is to employ strict controls to ensure adequate diversification and to protect the interests of investors.

Lastly, in a globalised world, investors need also remember that they can get exposure to the economic successes of these new markets both through the offshore listings of their native companies and through companies in developed markets with significant revenue in developing economies.

1Quick Reference Tables, The World Bank, September 2009

2MSCI Barra

3Emerging Markets: Practical Considerations, Karen Umland, Dimensional, 2003

4BHP Billiton preliminary results, June 30, 2009

5Parliamentary testimony, Reserve Bank of Australia, Aug 14, 2009, Hansard

6S&P-500 Global Sales, July 14, 2009

Posted by: Scott Keefer AT 09:27 pm   |  Permalink   |  Email
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