Investing in Emerging Markets
Summary
TLDRThe video script by Ben Felix, a portfolio manager at PWL Capital, debunks the myth that high economic growth in emerging markets correlates with higher investment returns. Instead, historical data reveals a negative relationship. Felix discusses the risks and nuances of investing in these markets, including economic recovery, diversification benefits, and the impact of market integration. He also highlights the importance of considering costs, factor premiums, and the unique risks associated with negative skewness in emerging markets.
Takeaways
- 📈 The term 'emerging markets' was created in 1981 by the International Finance Corporation to attract foreign investment into developing economies.
- 🌍 Emerging markets constitute about 10-12% of the global free float market capitalization and include approximately 25 countries like China, India, and South Korea.
- 🔍 Contrary to a common myth, economic growth does not necessarily correlate with higher investment returns; historical data shows a negative correlation between the two.
- 📊 High growth expectations and earnings in emerging economies are often priced in, which can lead to lower stock market returns due to earnings being spread across more shares.
- 💡 The economic footprint of emerging markets is larger than their representation in financial indexes due to factors like foreign ownership restrictions and free float weights.
- 📊 Emerging markets are more volatile but offer diversification benefits, potentially due to incomplete market integration and higher local risk factors.
- 💰 The cost of capital in emerging markets is lower, which can lead to more investment and economic growth, supported by empirical evidence from market liberalization studies.
- 📉 Emerging markets have historically underperformed developed markets, with significant periods of negative skewness indicating higher disaster risk.
- 🌐 The integration level of emerging markets is crucial for investors, as it affects diversification benefits and expected returns, with markets becoming more integrated over time.
- 💼 Factor premiums such as value, size, and profitability are present in emerging markets and can offer higher expected returns at different times compared to developed markets.
- 💸 Investors should be cautious about the costs associated with investing in emerging markets, including management fees, trading expenses, and foreign withholding taxes, which can significantly impact returns.
Q & A
Who coined the term 'emerging markets' and when was it first used?
-The term 'emerging markets' was coined in 1981 by the International Finance Corporation.
What percentage of the global free float market capitalization do emerging markets currently represent?
-Emerging markets make up roughly 10 to 12% of the global free float market capitalization.
How many countries are typically included in the definition of emerging markets?
-Emerging markets represent around 25 countries, including major economies like China, Taiwan, India, South Korea, and until recently, Russia.
What is the common myth about the relationship between economic growth and investment returns that the script addresses?
-The common myth is that economic growth and investment returns are positively related, meaning that higher growth economies should yield higher investment returns, which the script refutes.
According to the 2014 Credit Suisse Global Investment Returns Yearbook, what was the cross-sectional correlation found between real equity returns and real per capita GDP growth?
-The cross-sectional correlation found was negative 0.29, indicating that there is a negative relationship between real equity returns and real per capita GDP growth.
What does the script suggest about the reasons for historically lower stock market returns in countries with stronger economic growth?
-The script suggests that expected growth and earnings are priced into high growth economies, and growing profits are spread across an increasing number of shares as new businesses emerge, leading to less earnings per share growth.
How does the script describe the effect of war on the economies and investment returns of war-torn countries compared to non-war-torn countries?
-The script describes that while war-torn countries' economies can recover significantly, their dividend growth trails their economic growth by nearly twice as much as non-war-torn countries due to high rates of equity recapitalization.
What is the script's stance on the idea of using expected economic growth as a reason to overweight emerging markets in a portfolio?
-The script argues against using expected economic growth as a reason to overweight emerging markets, due to the historical evidence of lower stock market returns in high growth economies.
How does the script explain the concept of 'free float' and its significance in the context of emerging markets?
-Free float measures the value of shares available for trading, excluding shares owned by entities like state-owned enterprises. The script explains that free float weights as a percentage of total company capitalization are typically higher in developed markets, affecting how the size of investible capital markets is perceived by foreign investors.
What are the implications of market integration for investors in emerging markets, as discussed in the script?
-The script discusses that in a segregated market, assets are priced based on local risk factors leading to higher expected returns, whereas in an integrated market, assets are priced based on their contribution to the risk of the market portfolio, leading to lower expected returns due to diversification benefits.
How does the script address the issue of costs and risks associated with investing in emerging markets?
-The script addresses costs and risks by discussing the higher volatility of emerging markets, the potential for disaster risk due to negative skewness, the impact of foreign withholding tax, and the importance of considering the multi-factor structure of expected returns.
What advice does Ben Felix, the portfolio manager at PWL Capital, offer regarding the allocation to emerging markets in a diversified portfolio?
-Ben Felix advises that emerging markets deserve a place in a well-diversified portfolio but cautions against aggressively overweighting this asset class in pursuit of higher expected returns, suggesting that free float capitalization weights are a sensible starting point.
Outlines
🌐 Myths and Realities of Emerging Markets Investing
This paragraph delves into the concept of emerging markets, introduced by the International Finance Corporation in 1981, and their significance in today's global economy. It challenges the common belief that high economic growth directly correlates with higher investment returns, citing studies by Dimson, Marsh, Staunton, and Jay Ritter that show a negative correlation between economic growth and equity returns. The explanation provided involves the dilution of earnings per share growth due to an increase in the number of shares as new businesses emerge. The paragraph also highlights the unique case of China's stock market underperformance despite rapid economic growth and discusses the economic footprint of emerging markets in relation to their representation in financial indexes.
📈 Diversification and Risk in Emerging Markets
The second paragraph explores the dynamics of market integration and its impact on investment returns. It explains how assets in segregated markets are priced based on local risk factors, leading to higher expected returns due to limited diversification opportunities. In contrast, integrated markets offer lower expected returns due to the diversification benefits they provide. The paragraph also discusses the implications of financial market liberalization on expected returns and economic growth, the potential premium earned by investors in partially integrated markets, and the importance of considering the integration level of emerging markets. Additionally, it touches on the concept of skewness in asset returns, particularly the negative skewness observed in emerging markets, and its impact on portfolio risk and expected returns.
📊 Historical Performance and Factor Premiums in Emerging Markets
This paragraph examines the historical performance of emerging markets compared to developed ones, noting the underperformance of the former over the full period from 1900 to 2020, with a significant downturn attributed to the post-World War II period. It then presents a more optimistic view from 1960 onwards, where emerging markets have outperformed developed markets, albeit inconsistently. The discussion shifts to the presence of multi-factor premiums in emerging markets, such as value stocks, which have shown substantial outperformance compared to the U.S. market. The paragraph also addresses the higher costs associated with investing in emerging markets, including management fees, trading expenses, and the impact of foreign withholding taxes, especially in registered accounts like RSPs or TFSAs.
🔍 Navigating the Complexities of Emerging Market Investments
The final paragraph offers insights into the complexities of investing in emerging markets, emphasizing the importance of a cautious approach when considering overweight positions in pursuit of higher expected returns. It suggests using free float capitalization weights as a starting point for portfolio allocation and highlights the benefits of seeking exposure to multiple risk factors within emerging markets. The paragraph also discusses the availability of low-fee ETFs that offer such exposures and the importance of considering the definitions of emerging markets used by different index providers to avoid mismatches in investment products. Ben Felix concludes by advocating for a balanced strategy and invites viewers to engage with additional content on the topic.
Mindmap
Keywords
💡Emerging Markets
💡Portfolio Manager
💡Economic Growth
💡Investment Returns
💡Free Float Market Capitalization
💡Cost of Capital
💡Volatility
💡Diversification
💡Factor Premiums
💡Coskewness
💡Foreign Withholding Tax
💡MSCI
Highlights
The term 'emerging markets' was first used in 1981 by the International Finance Corporation to attract foreign investment in developing economies.
Emerging markets currently represent 10-12% of the global free float market capitalization and include about 25 countries.
Investors are sometimes misled to believe that higher economic growth directly correlates with higher investment returns, which is not supported by historical data.
Studies have shown a negative correlation between economic growth and investment returns, contradicting common investment myths.
High growth economies may have lower stock market returns due to high expectations already priced in and earnings spread across more shares.
War-torn countries can recover economically but may have lower dividend growth due to the dilution from equity recapitalization.
China, despite significant economic growth, has delivered lower stock market returns compared to developed markets.
Emerging markets have a larger economic footprint than their representation in financial market indexes due to investibility restrictions.
Free float weights, which measure the value of shares available for trading, are typically higher in developed markets than in emerging ones.
Emerging market stocks are volatile but offer diversification benefits, potentially due to incomplete market integration.
In segregated markets, assets are priced based on local risk factors, leading to higher expected returns compared to integrated markets.
Lower expected returns in integrated markets benefit the real economy by reducing the cost of capital for businesses.
Investors in emerging markets before full integration can expect to earn a premium as markets liberalize and integrate.
The integration level of emerging markets is crucial for investors, with more integration leading to lower expected returns and higher covariances with the market portfolio.
Emerging markets exhibit a more pronounced negative skew in stock returns, indicating a higher risk of extreme negative outcomes.
Negative coskewness of emerging markets with the MSCI World portfolio suggests a need for higher expected returns to compensate for disaster risk.
Despite underperformance in the past, emerging markets have outperformed developed markets since 1960, but only 42% of the time over 25-year periods.
Factor premiums such as value, size, and profitability are present in emerging markets and can offer higher returns compared to developed markets.
The costs associated with investing in emerging markets, including management fees, foreign withholding tax, and双层 foreign withholding tax, can significantly impact returns.
Index providers may have different definitions of emerging markets, which can lead to discrepancies when mixing investment products.
A balanced approach to investing in emerging markets is recommended, considering their potential for diversification and factor premiums, alongside risks and costs.
Transcripts
- 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)
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