Investing in Emerging Markets

Summary

The 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.