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1 Net An Emerging Introduction Replacement Markets: to Ratio Private Alpha Equity enhancing?

2 Emerging Markets: Alpha enhancing? 02 Emerging Markets: Alpha enhancing? GraySwan Research November 2013 Introduction Should all investors take the next exit off the investment highway and invest in emerging markets? Emerging markets have attracted the attention of investors and analysts alike with the economic turmoil and lacklustre growth prospects in developed markets. In this article we highlight key considerations when considering emerging markets and identify whether emerging markets are in fact alpha enhancing. Executive Summary Globally, investment markets are volatile. Investors are therefore looking firstly to diversify their portfolio and secondly to enhance returns. Many investors have considered emerging markets as an investment opportunity that could improve their portfolio s risk return characteristics. Emerging markets have rewarded investors with higher returns over the last 10 years than developed markets. It has proven to be alpha enhancing over this period. However, the higher return also brings with it higher risk. The large dispersion in returns from individual emerging markets suggests that selecting a particular emerging market could be risky and that selecting a basket of markets such as the BRIC index or Emerging Market index offer more diversified and less risky options. Why Emerging Markets? In a previous research report prepared by GraySwan, we investigated and analysed the growth outlook of the BRIC (Brazil, Russia, India and China) countries and highlighted the various important risks. The results of the BRIC research report motivated us to expand our analysis to emerging markets. This report should therefore be read in conjunction with our previous BRIC research report. China and India are ancient civilizations with a long history of being significant economies on the world stage in every aspect such as economic, military, cultural, trade and population. According to research done by Angus Maddison, in 1820 and for the previous 18 centuries, Asia s share of global GDP was 1 over 59%. Asia missed the industrial revolution and the relative share dipped sharply and bottomed out in 1950 at 19%. Since then we have seen a remarkable rise in Asia s share of the global economy with an estimated 48% in In the early 1980 s, China embarked on its industrialisation and modernisation with great success. India abandoned its Fabian socialism in the early 1990 s and embarked on a faster growth path. Analysts believe that Asia will remain dominant in the next 10 years and will represent an even larger share of the global economy. It is imperative for any investor to realise that when selecting to invest in emerging markets, these investments should be treated as long-term investments with investment horizons in excess of 5 years (but in reality closer to 10 years). Emerging markets are complex and require specialised skills to analyse and interpret these markets. 1 2 Angus Maddison. International Monetary Fund. April World Economic Outlook: Growth Resuming, Dangers remain. The three main reasons why Emerging Markets offer an investment opportunity worth investigating are as follows: GDP growth All of the 10 fastest growing economies in the world over the last two decades were from emerging markets. The 10 fastest growing economies forecasted over the next five years to according to the IMF are also to come from countries in emerging markets.

3 Net An Emerging Introduction Replacement Markets: to Ratio Private Alpha Equity enhancing? World s ten fastest growing economies Annual average GDP growth forecasted %, Average average (actuals) China 9.86 Myanmar 9.76 Angola 9.12 Mozambique 7.98 Cambodia 7.61 Vietnam 7.10 Ethiopia 6.96 Uganda 6.93 India 6.78 Nigeria 6.38 Note: Large, non-crisis economies Source: IMF, GraySwan Investments. Data as at April Apart from the pace of growth, the sizes of these economies are 3 also projected to dominate the economic front. PwC has run models projecting the GDP of all economies by More than half of the top 20 economies will be emerging markets China United States India Brazil Japan Russia China is projected to overtake the United States as the largest economy by Russia is projected to overtake Germany as the largest European economy before Population and Demographics Top 20 Economies in 2050 GDP at PPP rankings 2012 Mexico Indonesia Germany average (forecasted) Guinea China 8.45 Mozambique 7.88 Zambia 7.80 Côte d'ivoire 7.65 Cambodia 7.41 Nigeria 6.98 Tanzania 6.89 Burkina Faso 6.85 Uganda 6.84 France Favourable demographics from a rapidly growing population and workforce, to urbanisation and growth in the middle class are making analysts and investors sit up and take note. The World Bank is quoted as saying that a new engine of private demand growth will be needed, and we see a likely candidate in the still largely untapped consumption potential of the rapidly expanding 4 middle classes in the large emerging market countries. The United Kingdom Source: Worlds Bank, PwC model projections. Turkey Italy Spain Canada Nigeria South Korea Saudi Arabia Australia Argentina middle class is seen as the engine of growth and a growing middle class indicates a growing potential for economic growth. Given their huge populations, much is made of the sheer weight of China and India as investment destinations. Economic Fundamentals Stable long-term foreign capital inflows into emerging markets suggest that the medium to long term prospects remain optimistic. There are easing of inflationary pressures and after a long period of interest rate tightening, there are signs of a reversal in the interest rate cycle. Economists believe that emerging market countries still have plenty of room to loosen monetary policy and 5 provide fiscal support. It is however important to note that developed markets such as Europe and the US are the main export markets for the emerging markets. Economic growth for emerging markets will be affected as the Eurozone and the US struggle with slow growth. Considerations when adding investments Before we start analysing emerging markets, we need to first answer the following question. Why would we consider adding any offshore exposure, developed markets or emerging markets, to the portfolio of a South African investor in the first place? There are three key factors that should be weighed up when constructing a portfolio and adding asset classes: 1.) 2.) 3.) The expected return of each additional investment; The volatility (or risk) of each additional investment; The correlation of the additional investment relative to the existing investments in the portfolio. It is good portfolio construction practise to first assess whether any additional investment enhances the risk and return characteristics of the current portfolio before investing. One should never add investments just for the sake of adding another investment. Do emerging markets make sense for South African investors? The scatterplot on the next page has been extracted from the GraySwan Offshore BRICS Market Summary Performance Report which we provide to our clients on a monthly basis. It compares the risk and return characteristics of emerging market, developed market and South African equities in US Dollar terms. In terms of emerging markets have we simply used some of the major markets such as Brazil, Russia, India and China as a proxy for these markets. 3 PwC. January World in 2050 The BRICs and beyond: prospects, challenges and opportunities. The Economist. February Burgeoning bourgeoisie. PwC. February Economic Views BRICs. 4 5

4 Emerging Markets: Alpha enhancing? 04 Emerging markets have rewarded investors with higher returns over the last 10 years than developed markets as represented by the World index. However, the higher return also brings with it higher risk. This indicates that if an investor has to decide between developed markets or emerging markets he will have to consider return as well as risk characteristics and how it fits into his investment strategy. Data for the 10 year period ending September year Correlation Matrix ACWI World Data for the 10 year period ending September EM BRIC Brazil Russia India China ACWI World EM BRIC Brazil Russia India China South Africa South Africa Further, we assess whether there is any diversification benefits to be obtained by adding emerging markets to the portfolio of a South African investor. As a rule of thumb, a correlation figure below 80% is seen as not strongly correlated. The South African equity market is correlated with developed markets as represented by the World index. There is also a strong correlation between South African and emerging market equities as represented by the Emerging Markets index. South Africa is more highly correlated to emerging market equities than to developed equity markets indicating that diversification from a correlation perspective alone is not a strong argument for investing in emerging market equities. Currency Research shows that emerging market currencies tend to 6 co-move to the South African Rand. This suggests that emerging market currencies may not provide South African investors with a Rand hedge that can be achieved by investing in developed markets. Market performance GraySwan has conducted extensive quantitative research in comparing emerging markets with developed markets. We started by comparing emerging market equities as a whole to developed market equities. We then carved out the BRIC markets from the emerging market universe and finally we analysed each of the underlying markets making up the BRIC group namely Brazil, Russia, India and China. The GraySwan Global Equity Benchmark survey which we produce every month for our clients compares the performance and risk statistics of the various equity markets. We firstly wanted to assess whether the performance attained by the emerging equity markets are attractive enough to warrant further investigation. Below is the annual performance attained by each of these equity markets since the market turmoil in Cadiz Securities. 24 March Should we join the flight to emerging markets?

5 Net An Emerging Introduction Replacement Markets: to Ratio Private Alpha Equity enhancing? *Data for the period ending September Calendar Year Period Brazil Russia India China South Africa BRIC* World % % % 62.28% 57.81% 93.11% 29.99% % 19.05% 20.95% 4.63% 34.21% 9.57% 11.76% % % % % % % -5.54% % 13.66% 25.97% 22.75% 18.69% 14.54% 15.83% 2013* % 0.43% % -0.16% -8.34% -5.11% 17.29% During 2009, emerging equity markets produced phenomenal returns of multiples of developed markets as represented by the World index. This was however followed by muted returns during 2010 and very disappointing returns during delivered a mixed bag of returns for emerging markets ranging from as low as 0.05% for Brazil and up to 25.97% for India. The large dispersion in returns yielded from individual emerging markets suggests that selecting a particular emerging market could be risky and that selecting a basket of markets such as the BRIC index or Emerging Market index offer more diversified and less risky options. The year to date ending September 2013 has once again produced disappointing results for emerging markets as these markets have substantially underperformed the World index. Risk Statistics Maximum Loss (Peak to Trough) Data for the 10 year period ending September The standard deviations of emerging markets are higher than that of the World index. This indicates that the risk associated with the emerging markets is higher than the risk associated with developed markets. The maximum loss statistics for emerging markets also re-emphasises the inherent risk in these markets. Actively managed funds Brazil 7 According to research done by GraySwan Investments, investment manager selection is critical and can add substantial alpha if done carefully. The investment manager selection process should therefore not be taken lightly. 10 years Absolute Risk Comparison Russia India China South Africa BRIC* World Standard Deviation 32.71% 34.66% 32.35% 28.10% 26.95% 27.95% 16.12% Upside Deviation 21.02% 20.29% 20.49% 16.94% 16.53% 17.10% 8.96% Downside Deviation 17.78% 20.93% 17.94% 16.38% 15.25% 16.30% 10.33% Lowest Monthly Return % % % % % % % % % % % % % % 7 GraySwan Investments The Critical Importance of Investment Manager Selection.

6 Emerging Markets: Alpha enhancing? 06 Summary An investor should only consider adding an additional investment if it enhances the risk and return characteristics of the existing portfolio. South Africa is more highly correlated to emerging markets than to developed markets indicating that diversification from a correlation perspective alone is not a strong argument for investing in emerging markets. The large dispersion in returns from individual emerging markets suggests that selecting a particular emerging market could be risky and that selecting a basket of markets such as the BRIC index or Emerging Market index offer more diversified and less risky options. It is imperative for any investor to realise that when selecting to invest in emerging markets, these investments should be treated as long term investments with investment horizons in excess of 5 years (but in reality closer to 10 years). Due to the complexity of these markets and the specialised skills required to analyse these markets separately, it would be best to select investment managers to make the decision of which markets to access. When selecting an investment manager, the investor should decide whether an active investment manager approach or a passive tracker fund approach is best suited for the investor s needs. If an active approach is selected then the investor will need to consider whether a single or multiple investment manager approach or even a fund of funds approach is most optimal. At this point the mandate process is key, which details the benchmark used, the optimal fee structure, cash withdrawal notifications, lock-up periods and many other important aspects. Gregoire Theron Head of Manager Research Karlien de Bruin Senior Investment Analyst