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Benefits and Pensions MonitorGot Emerging Markets?By: David M. Shepherd Imagine a global portfolio that excluded the equity markets of almost half the world’s output and economic growth and more than 80 per cent of the world’s population. While the notion may seem absurd, it is actually commonplace as emerging markets are excluded or under-represented in many Canadian portfolios. With the recent removal of the foreign property limit for Canadian pension funds, many plans need to reassess their commitment to emerging markets. Background The MSCI Emerging Markets Index, which began in 1988, includes 26 countries in the Americas, Asia, Eastern Europe, Africa, and the Middle East. There are several other emerging countries beyond these 26. However, exchange controls, liquidity, and political risk can be impediments to investing in these ‘preemerging’ markets. Combined, the 26 countries in the MSCI Emerging Markets Index represent approximately seven per cent of global equity market capitalization and about 40 per cent of the world’s economy (using PPP-adjusted totals). Canadian markets by comparison represent approximately 3.5 per cent of global equities and less than two per cent of the world’s economic output. The economic characteristics of many of the emerging market countries are impressive. Annual economic growth in the emerging markets has averaged 5.4 per cent since 1996 versus 2.6 per cent for industrial economies, says the World Economic Outlook. Seven of the 10 largest central bank holdings of foreign reserves are emerging market countries and 11 of the 26 countries hold reserves greater than the roughly $30 billion held by the Bank of Canada. In sharp contrast to previous decades, inflation for most of these countries is in the low single digits and their currencies are stable or strengthening. Performance And Volatility Performance and volatility are often cited as concerns regarding investing in the emerging markets. While the MSCI Emerging Markets Index has outperformed the MSCI Canadian Index since its inception (see Chart 1), the returns of the Emerging Markets Index have been more volatile and returns to Canadian investors were lower when converted to Canadian dollars. In seven of the 18 years since inception of the MSCI Emerging Markets Index, returns in Canadian dollars have been negative. The largest decline was 29.4 per cent (2000) and the largest gain was 78.6 per cent (1993). This compares to four years of negative returns (out of 18) for the MSCI Canada Index with the largest decline of 15 per cent (2001) and the largest increase of 45.9 per cent (1999).
One strategy to gain emerging markets exposure is by investing in domestic companies doing business in the emerging markets. While many Canadian companies benefit from emerging markets growth, this strategy may not provide adequate exposure to these markets. According to International Trade Canada, two emerging market countries (China and Mexico) are in the top five of Canada’s export destinations. However, developing countries as a whole represented less than 10 per cent of Canada’s merchandise exports in 2005. By contrast, developing countries represented almost 25 per cent of Canada’s merchandise imports for that year. Exports to Asia, particularly China and India, represent almost half of Canada’s exports to the developing markets, and pulp and chemicals represent almost one-third of those exports. Based on these statistics, a naively-constructed portfolio of Canadian exporters risks being overweight China and India (eight per cent and six per cent of the MSCI Emerging Markets Index, respectively) and overweight materials (13 per cent of the MSCI Emerging Markets Index). Recognizing the potential benefits of investing in the emerging markets, many plans have allowed their international managers to invest in the emerging markets as part of an EAFE or global mandate. There are some drawbacks to this approach. Portfolio managers may be hesitant to include emerging markets if they are not also included in their benchmark. For example, a recent study by the Russell Investment Group found the median allocation to the emerging markets in global portfolios was 0.53 per cent at year-end, well below the seven per cent that these markets represent of global market capitalization. As they comprise a small segment of most global portfolios, the emerging markets component may include only a few stocks, representing potentially even fewer countries. There is a likely to be a bias towards the large capitalization stocks with the greatest liquidity when adding emerging markets in this way. How To Invest Plans seeking to gain additional exposure to emerging markets have several options. Separate mandates allow investors to customize their emerging markets exposure in a number of ways (style, region, sector, currency), but typically require larger minimum commitments than fund products. A number of investment managers offer pooled products that have lower minimums and allow investors to share expenses. For those convinced of the benefits of passive management, there are a variety of fund products and exchange-traded funds (ETFs) that track the popular emerging markets indices. Regardless of the investment product, investors will find the costs to investing in emerging markets, while declining, tend to be higher than in the developed markets. For plans seeking global diversification, the emerging markets have become too big to ignore. With the elimination of the foreign property limit, and the continued growth in these markets, Canadian plans should reassess their approach to investing in this asset class. David M. Shepherd, is a principal, client service and marketing, at Marvin & Palmer Associates, Inc. |
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