Investing in Emerging Markets - YouTube

- The term emerging markets was coined in 1981

by the International Finance Corporation

as a marketing term to help make the case

for foreign investors investing in developing economies.

Today, emerging markets make up roughly 10 to 12%

of the global free float market capitalization,

representing around 25 countries, including China, Taiwan,

India, South Korea, and until recently, Russia.

Characteristics like high economic growth expectations

and attractive valuations compel some investors

to overweight emerging markets in their portfolios.

But there are some often overlooked facts,

costs and risks that should be carefully considered.

I'm Ben Felix, portfolio manager at PWL Capital.

I'm going to tell you about the intricacies

of investing in emerging markets.

One of the longest running myths in investing

is that economic growth and investment returns

are positively related.

That is if you invest in the highest growth economies

or sectors, you will earn higher investment returns.

The reality is the exact opposite.

This is documented in detail by Dimson, Marsh and Staunton

in the 2014 Credit Suisse

Global Investment Returns Yearbook,

where they find a cross-sectional correlation

of negative 0.29 between real equity returns

and real per capita GDP growth

for 21 countries with continuous stock market histories

from 1900 to 2013.

In a 2012 paper,

titled "Is Economic Growth Good for Investors?"

Jay Ritter found similar results

for 19 primarily developed markets from 1900 through 2011,

with a negative cross-sectional correlation of 0.39.

Ritter also looked at a sample

of 15 emerging market countries for the 24-year period

from 1988 through 2011,

including Brazil, Russia, India and China,

and found a similarly negative cross-sectional correlation

of negative 0.41.

This evidence suggests that countries

with stronger economic growth

have historically had lower stock market returns.

The reasons are probably a combination of expected growth

and earnings being priced into high growth economies,

and growing profits in these economies

being spread across an increasing number of shares,

as new businesses emerge

to meet the demands of a growing economy.

If aggregate earnings grow, but lots of new businesses start

or existing businesses raise new equity capital,

earnings per share growth,

which is what matters for stock returns,

will rise less,

due to earnings being spread across more shares.

An interesting laboratory to observe this effect

is war-torn and non-war torn countries from 1900 to 2000,

as demonstrated by William Bernstein and Rob Arnott

in their 2003 paper,

"Earnings Growth, The Two Percent Dilution."

Bernstein and Arnott show that while war-torn countries

had their economies devastated by war,

within little more than a generation,

their GDP caught up to, or surpassed,

the GDP of non-war-torn countries.

Despite their impressive economic recoveries,

war-torn countries' dividend growth

trailed their economic growth measured by per capita GDP

by nearly twice as much

as the non-war-torn countries in the sample.

The explanation for the larger gap

is that war-torn countries had to go

through a high rate of equity recapitalization.

New companies needed to form

and existing companies needed to raise new capital

for the economic recovery,

diluting the benefits of economic growth

for existing shareholders.

A nice anecdotal example is China.

Despite massive economic growth

by any measure that you can think of,

the Chinese stock market has delivered

substantially lower returns

than international developed markets.

While expected economic growth may not be a reason

to overweight emerging markets,

there are some other good arguments.

Emerging markets have a much larger economic footprint

measured by things like GDP population and land mass

than their weight in financial market indexes.

One of the reasons for this is that index providers

typically focus on the investible market

from the perspective of a global investor,

meaning that foreign ownership restrictions

in some countries reduce the size

of their investible capital market

from the perspective of a foreign investor.

China's A-Shares are a good example.

MSCI excluded them until 2018,

and even now, only allocates 20%

of their actual free float capitalization in their indexes.

The other big contributor is the use of free float weights.

Free float measures the value of shares

that are available for trading,

excluding shares owned by, for example,

state-owned and enterprises and company founders.

Typically, free float weights as a percentage

of total company capitalization are much higher

in developed markets than in emerging markets.

There are some other important details to know

about how this asset class fits into a portfolio.

Emerging markets stocks tend to be volatile,

but they also tend to have diversification benefits

with respect to the developed market portfolio.

One of the reasons for this diversification benefit

may be incomplete market integration.

An integrated market is fully open to foreign investors

and for domestic investors to own foreign assets,

while a segregated market is completely closed.

Think about an investor in a country

who cannot invest outside of their own country,

and no companies in their country

can raise capital from foreign investors.

In that case, only local economic risks matter

in determining an asset's expected return,

and expected returns will tend to be higher

since investors are unable to diversify their risk.

An investor in a country like Canada, on the other hand,

where you can invest globally,

will assess expected returns based on the asset's

risk contribution to the market portfolio,

rather than on the local risk factors.

In a segregated market,

assets will be priced based on local risk factors,

and expected returns will tend to be higher,

whereas in an integrated market,

assets will be priced based on their contribution

to the risk of the market portfolio

and expected returns will tend to be lower

due to this diversification benefit.

Lower expected returns sound bad,

but for the real economy of an emerging market,

lower expected returns are great.

The expected return is the cost of capital

that the businesses listed on the stock exchange

used to assess projects.

A low cost of capital should mean more investment

in projects and more economic growth.

This is confirmed empirically in the 2000 papers

"Foreign Speculators and Emerging Equity Markets"

and "Equity Market Liberalization in Emerging Markets."

When countries liberalize their financial markets,

their expected returns tend to fall,

and GDP growth tends to increase.

The other implication here

for investors in emerging markets

is that if you are invested before complete integration,

you expect to earn a premium as expected returns fall

and prices rise as the market liberalizes and integrates.

Of course, this premium can't be predicted or timed,

and it's definitely not guaranteed.

A partially integrated financial market can deliver

a diversification benefit and a high expected return.

But as emerging markets liberalize

and begin to integrate allowing foreign investors in,

their expected return should fall

or their co-variances with the market portfolio

should increase as foreign capital

absorbs the diversification benefit.

An asset with a low covariance with the market,

and a high expected return would be a free lunch,

and its price would quickly be bid up,

meaning its expected return would fall

to the point that its expected return

matches its risk contribution to a diversified portfolio.

The extent to which emerging markets are integrated

is another important question

for investors considering this asset class.

Empirically, based on the paper

"What Segments Equity Markets?"

emerging markets have become more integrated over time

but are still more segregated than developed markets.

This implies an ongoing diversification benefit.

Additionally, while correlations between developed

and emerging market returns have increased since the 1980s,

they have remained imperfect at around 0.8.

Emerging markets have another unique property

that needs to be considered.

Looking only at the mean and variance

of an asset's contribution to a portfolio

assumes that the returns follow a normal distribution,

ignoring an important statistical measure called skewness.

Skewness measures the asymmetry of a distribution.

Aggregate stock market returns

are negatively skewed in general,

meaning that returns are generally

more positive than negative,

but there are infrequent extreme negative.

Emerging markets exhibit

an even more pronounced negative skew

than stock markets in general.

We can think about this as disaster risk.

Similar to volatility, we don't actually care

about the skewness of an individual asset on its own.

We care about the contribution of the asset's skewness

to the skewness of the overall portfolio,

a measure called the coskewness.

As it turns out, as documented

in "Drivers of Expected Returns in International Markets,"

emerging markets have historically had negative coskewness

with the MSCI World portfolio,

meaning that adding them to the portfolio

makes the overall portfolio's skewness more negative.

This property, negative coskewness,

should increase the expected return of an asset.

Negative skewness is not something

that most investors want in their portfolio

so they need a higher expected return to compensate.

In "Conditional Skewness and Asset Pricing Tests,"

we learn that both in the theory and the empirical data,

negative cost skewness does in fact command

a meaningful risk premium.

Maybe this sounds enticing for any risk-seeking investor,

another priced risk,

but the type of disaster risk

that has historically shown its face in emerging markets

might make you think twice.

looking at developed and emerging market portfolios

from 1900 through 2020,

it may be surprising to see that emerging markets

have trailed developed markets for the full period.

This underperformance is largely due

to a disastrous period from 1945 to 1949.

Japan lost 97% and Chinese markets were closed in 1949,

following the communist victory.

There were other poor performers,

but these examples demonstrate the extreme disaster risk.

It's easy to brush this off

and say that this type of collapse couldn't happen today.

But emerging markets generally have greater political risk,

less developed stock markets and tighter control

on foreign investors than developed markets do.

Disaster risk may be showing up in Russia right now.

Russia was previously classified as an emerging market,

and at the time of recording, has been demoted

by index providers to a standalone market,

due to its stock market no longer being investible.

There is a risk premium

for that left tail risk for a reason,

but it's important to realize that negative skewness

may not be as easy to ride out

and recover from as volatility.

Changing the start date to 1960,

emerging markets have outperformed developed markets.

But looking at 25-year rolling periods from 1900 to 2020,

emerging markets have only beat developed markets

42% of the time.

The multi-factor structure of expected returns

that exist in developed markets

also seems to be present in emerging markets.

Emerging markets factor premiums have been substantial

and have shown up in the recent period,

where they've been largely absent in developed markets.

Value is a good example.

That is stocks with owe prices relative

to their business fundamentals, like book value.

Typically they outperform,

but in the U.S. for the 20 years ending December, 2021,

value stocks have trailed the market

by a painful 1.69% per year,

leading many people to claim that value is debt.

Meanwhile, over the same period, emerging markets value

has beaten the emerging markets index by 1.91% per year,

and beaten the U.S. market by 2.77% per year.

Other factor premiums like company size and profitability

have also been positive in emerging markets.

Emerging markets are volatile,

but they offer diversification

to developed markets portfolios.

They also have high expected returns,

but some of those high expected returns come at the cost

of negative skewness, which can really hurt,

even if you do have a long-time horizon.

Factor premiums exist in emerging markets

and have historically shown up at different times

than U.S. and developed market premiums.

The last thing to consider is costs.

Comparing the iShares Core MSCI

Emerging Markets IMI Index ETF, XEC,

with the iShares Core MSCI EAFE IMI Index ETF, XEF,

which is a developed markets index,

the management fee and trading expense

add roughly five basis points for emerging markets.

That's not too bad,

but the bigger issue is foreign withholding tax.

When a stock in a country

pays a dividend to a foreign investor,

the source country will often withhold some tax.

This withholding tax is typically recoverable

in a taxable investment account for a Canadian investor,

because it can be used as a credit

against Canadian taxes owing.

But in a registered account, like an RSP or a TFSA,

the foreign withholding tax is not recoverable.

There are a couple of issues here.

Emerging market stocks tend to have higher yields

than developed market stocks.

This means that more of your returns

come in the form of foreign dividend income.

That alone increases the cost of ownership

in both taxable accounts, due to taxes on foreign dividends,

which are fully taxable,

and in non-taxable accounts,

due to unrecoverable foreign withholding tax.

On top of that, the withholding tax rate

from emerging markets countries tends to be higher.

The result is generally higher income tax

and withholding tax costs for emerging market stocks.

But it actually gets worse.

If you own a Canadian-listed ETF

that owns a U.S.-listed ETF of emerging market stocks,

rather than owning the underlying stocks directly,

you get hit with a second layer of foreign withholding tax.

In Canada, there are no Canadian domiciled emerging markets

index funds targeting large, mid, and small caps

that hold securities directly.

XEC from iShares and VEE from Vanguard

both hold their U.S.-listed equivalent.

For example, the total unrecoverable

foreign withholding tax cost for owning XEF,

which holds developed market stocks directly,

in a taxable account, can be estimated at 0%,

since foreign taxes are recouped

if they can offset Canadian taxes,

while XEC, which holds a U.S.-listed ETF

of emerging market stocks gives up more than 0.3%

on the layer with holding tax

paid from foreign companies to the U.S.-listed ETF.

In a TFSA account, the difference is even bigger

with XEF losing a little more than 0.2%

and XEC losing more than 0.7%.

These additional fees and costs add up

and they weigh on the expected returns of this asset class.

One way around the withholding tax issue

is to own an ETF like ZEM,

which generally hold stocks directly,

but does not at small cap stocks.

The tradeoff here is between giving up

higher expected returns on smaller companies

for lower withholding tax burden.

The dimensional funds that my firm, PWL Capital,

uses in client accounts

also hold emerging markets stocks directly.

Some additional costs are not an issue,

if we expect emerging markets

to deliver a large premium over developed markets.

But as we've seen, that's not a sure thing,

especially if the deep left tail

decides to show up in your investment lifetime.

I don't think it's sensible to run

a portfolio optimization process based on things

like expected returns, covariances and coskewness

to find the theoretically optimal allocation

to emerging markets.

The output of that type of optimizer

is highly sensitive to its inputs,

and we only have past or expected inputs.

There's a good chance that the future will look different,

and our theoretical optimal portfolio will be suboptimal.

A quick final point is that not all index providers

have the same definition of emerging markets.

This is important because mixing and matching

investment products from different providers

can lead to problems.

The most significant example is South Korea,

which is the second largest emerging market

by market capitalization after China,

if you follow MSCI's indexes.

But FTSE Russell classifies it as developed.

This means that if you buy

a developed market's product tracking an MSCI index,

and an emerging market's product tracking a FTSE index,

you will have excluded South Korea entirely.

The other example is Poland,

which MSCI classifies as emerging

and FTSE classifies as developed.

Applying some common sense, I think emerging markets

deserve a place in a well-diversified portfolio,

but I would be cautious applying an aggressive overweight

to this asset class in pursuit of higher expected returns.

The free float capitalization weights

that most index providers use

are probably a sensible starting point.

If possible, seeking exposure to multiple risk factors

in emerging markets makes sense.

Fortunately, for investors,

ETFs from dimensional fund advisors and Avantis

are now offering these exposures in low-fee products.

Thanks for watching.

I'm Ben Felix, portfolio manager at PWL Capital.

If you enjoyed this video, please share it with someone

who you think could benefit from the information.

We also discussed this topic in episode 191

of The Rational Reminder Podcast,

and I would love it if you checked it out.

(upbeat music)