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Normandin Beaudry

Investing in emerging markets

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There, in black and white

NB Bulletin Vol. 13. N. 7, July 2010

With low interest rates, disappointing stock market performances and only modest expected economic growth in developed countries, many institutional investors are looking for new sources of return.

When it comes to investing the variable income portion of an investment fund for exposure to growth factors, emerging market equities are definitely an asset class to consider. In fact, with the strong rebound of their stock market and their economic growth returning to the level it was prior to the financial crisis, emerging markets deserve to be analyzed and followed closely.

Emerging markets: how do we distinguish them?

 An emerging market is a nation with a strong potential for sustainable economic growth, a relatively young and growing population, an expanding stock market and a rapidly liberalizing economy. Excellent examples are the BRIC countries, a term used in economic and financial literature that refers to the economies of Brazil, Russia, India and China.

A major contribution to the global economy

According to a CFA Institute analysis, the combined economies of the BRIC countries could eclipse the combined economies of the G6 (United States, Japan, Great Britain, Germany, France and Italy) by 2040. At the moment, the combined economies of the BRIC countries make up approximately 16% of the global gross domestic product (GDP); by 2040 they could represent close to half of the global GDP.

Here are some of the factors that should enable emerging markets to generate superior economic growth when compared to developed countries:

  • Favourable demographics, with a rapidly rising purchasing power of the main consumer cohort
  • Growth in infrastructure needs
  • Financial institutions with sound balance sheets
  • Governments recording surpluses

As a result of these factors, stock markets in emerging countries rebounded before those in developed countries during the last financial crisis and have generated higher returns over the last decade.

Investing in emerging markets

 There are three main investment vehicles that can be used to get exposure to emerging market equities:

  • A specialized emerging market equity mandate
  • A global equity mandate in which a portion of the assets are invested in emerging market equities
  • Direct investment in companies listed on the stock markets of developed countries that generate income in emerging markets

Certain institutional investors, depending on the size of their assets, prefer to grant global equity mandates which include emerging market equities rather than have two separate investment mandates. Selecting an investment vehicle also raises the question of an appropriate benchmark. Some institutional managers use the MSCI ACWI (All Country World Index), which includes all developed and emerging countries, because it is more representative of an equity mandate that includes investments in emerging markets.

Risks and manager selection

Certain risks apply more specifically to emerging market equities, such as political risk, corporate governance risk, contagion risk (risk that an event will impact all countries even though it actually affects only one country) and currency risk. In terms of currency exposure, emerging market equity portfolios must be diversified to minimize the impact of crises associated with a particular country or currency. It is also important to realize that the financial statements of companies listed on emerging market exchanges are generally less transparent.

Despite the strong investments in emerging market equities and increased coverage of this asset class by analysts, there are still very few passively managed products, mainly because of the high transaction costs. Active management should be favoured, considering the many sources of value added, such as the selection of countries, sectors, currencies as well as securities.

Given the risks associated with emerging market equities, the selection of a manager with in-depth expertise in this area and excellent knowledge of local markets is crucial. It should also be noted that due to significant investments in this asset class, many institutional products are closed to new investors.

To invest or not to invest?

 Emerging markets offer attractive growth potential and account for more than 10% of the world stock market capitalization compared to about 4% for Canada. Institutional investors must therefore position themselves with respect to this asset class. With equity diversification in mind, an institutional investor should consider investing a proportion of its assets in emerging market equities in the framework of an overall risk tolerance analysis.

 

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