Emerging Market Investing in a Globalizing World: Lessons for Institutional Investors

Transcription

1 International Centre for Pension Management OECD Conference Centre, Paris Emerging Market Investing in a Globalizing World: Lessons for Institutional Investors Campbell R. Harvey Duke University and Investment Strategy Advisor, Man Group, plc Revised January 18, 2017

2 Acknowledgements Joint work with my long time collaborator, Geert Bekaert. Emerging Equity Markets in a Globalizing World The empirical work for my exhibits were put together by Jenn Bender, Abhishek Gupta, Sivananth Ramachandran, Alejandra Cantu, and Manish Shakdwipee and Brett Hammond of MSCI. I also received valuable help from Su Ling Chee and Zhihui Yap at GIC. We appreciate the comments from seminar participants at the Ministry of Finance, Norway as well as Singapore s GIC as well as comments of two referees and Rodney Sullivan. Campbell R. Harvey

3 The Setting 22 years ago I began a research program that studied the characteristics of emerging market returns with a new database from the IFC Question back then: Should we invest in EM markets? Campbell R. Harvey

4 The Setting 21 years ago I began a research program that studied the characteristics of emerging market returns with a new database from the IFC Question back then: Should we invest in EM markets? Question today: How much should we invest in EM markets? Campbell R. Harvey

5 Key Questions Has the risk profile of emerging markets changed? Are emerging markets more integrated today? How much of a diversified global equity portfolio should be allocated to emerging markets? Broader Question: Should we even bother to distinguish between emerging and developed markets? Campbell R. Harvey

6 Developing Emerging Markets 1987: US + Japan = 43.8% of world GDP 1987: China 2.0% Rank Country GDP Weight Country GDP Weight 1 United States 29.0% United States 24.5% 2 Japan 14.8% China 15.0% 3 Germany 7.0% Japan 5.6% 4 France 5.6% Germany 4.6% 5 Italy 4.9% United Kingdom 3.9% 6United Kingdom 4.4% France 3.3% 7 Canada 2.6% India 2.9% 8 China 2.0% Italy 2.5% 9 Spain 1.9% Brazil 2.4% 10 Brazil 1.8% Canada 2.1% GDP data in U.S. dollars. Source: IMF World Economic Outlook Data for 2015 is as of April Campbell R. Harvey

7 Developing Emerging Markets Easy to extrapolate: Emerging and Developed Countries Share of World GDP 90% 80% 70% GDP (Weight%) 60% 50% 40% 30% Emerging market and developing economies Advanced Economies 20% 10% 0% Source: World bank, IMF. Shaded area uses IMF forecasts. Campbell R. Harvey

8 Weights Divergence in weights Emerging Markets GDP and Equity Market Shares Weight of emerging markets 40% 35% 30% 25% 20% 15% 10% 5% 0% Source: World Bank, IMF, MSCI. EM GDP Weight MSCI ACWI (Free Float Market Capitalization) Campbell R. Harvey

9 Weights EM equity skewed relative to their GDP Top 10 Over and Underweighted Countries in MSCI GDP Weighted Indices Source: MSCI. MSCI ACWI includes both developed and emerging market countries. MSCI ACWI GDP Weighted Index MSCI ACWI Index Difference Largest Overweights China 12.9% 2.4% 10.5% Germany 5.5% 3.0% 2.5% India 3.2% 0.8% 2.4% Brazil 2.8% 0.6% 2.2% Italy 2.7% 0.7% 2.0% Russia 2.2% 0.4% 1.8% Mexico 1.8% 0.4% 1.3% Indonesia 1.3% 0.3% 1.0% Turkey 1.1% 0.1% 0.9% France 4.2% 3.3% 0.9% Largest Underweights United States 28.2% 53.5% 25.3% United Kingdom 4.0% 6.5% 2.5% Switzerland 1.0% 3.1% 2.1% Japan 6.8% 7.7% 0.9% Hong Kong 0.4% 1.1% 0.7% Canada 2.5% 3.1% 0.6% Taiwan 0.7% 1.2% 0.5% Australia 2.1% 2.4% 0.3% South Africa 0.4% 0.7% 0.3% Sweden 0.8% 0.9% 0.2% Campbell R. Harvey

10 Weights MSCI ACWI GDP Weighted Index MSCI ACWI Index Difference CHINA 12.9% 2.4% 10.5% USA 28.2% 53.5% 25.3% UNITED KINGDOM 4.0% 6.5% 2.5% USA+UK 32.2% 60.1% 27.8% Source: MSCI. MSCI ACWI includes both developed and emerging market countries. Campbell R. Harvey

11 Free Float vs. Total Market Cap Less free float in EM Free Float (%) ACWI 81.1% World 87.3% EM 49.1% Developed Markets USA 94.8% Japan 73.2% Pacific ex Japan 73.2% Emerging Markets EM Asia 49.0% EM EMEA 49.0% EM Latin America 50.2% Source: MSCI. Average of companies' free float for constituents in the index. Campbell R. Harvey

12 Free Float vs. Total Market Cap Less free float in EM 40% 35% Weight of emerging markets 30% 25% 20% 15% 10% 5% 0% EM GDP Weight MSCI ACWI (Free Float Market Capitalization) MSCI ACWI (Total Market Capitalization) Source: MSCI. Average of companies' free float for constituents in the index. Campbell R. Harvey

13 Long term Performance Better returns but higher risk in EM Comparing the Performance Between Developed and Emerging MSCI World MSCI EM Average Annualized Excess Returns January 1988 to December % 7.13% January 1988 to December % 6.83% January 2001 to December % 7.38% Annualized Standard Deviation January 1988 to December % 23.23% January 1988 to December % 23.76% January 2001 to December % 22.81% Sharpe Ratios (annualized returns) January 1988 to December January 1988 to December January 2001 to December Beta vs. ACWI January 1988 to December January 1988 to December January 2001 to December Alpha (annualized returns) January 1988 to December % January 1988 to December % January 2001 to December % Note: The geometric average is used for average annualized excess returns above. Returns are in excess of a US Treasury bill. Source: MSCI and the St. Louis Federal Reserve. Campbell R. Harvey Note: Geometric average is used for average annualized returns above. Source: MSCI

14 Long term Performance Better returns but higher risk in EM Annualized USD five year returns Average Annualized Excess Returns (5Yr Trailing) 40% 30% 20% 10% 0% 10% 20% MSCI World (Developed Markets) MSCI Emerging Markets Note: Geometric average is used for average annualized returns above. Source: MSCI Campbell R. Harvey

15 Long term Performance Better returns but much higher risk in EM Annualized five year standard deviations 35% 30% Annualized Std Dev (5Yr Trailing) 25% 20% 15% 10% 5% 0% MSCI World (Developed Markets) MSCI Emerging Markets Source: MSCI Campbell R. Harvey

16 Long term Performance Better returns but higher risk in EM Downside and Tail Risk (Monthly Returns, in USD, January 1988 to December 2016) Source: MSCI MSCI World MSCI EM Average Monthly Total Return 0.7% 1.1% Standard Deviation 4.3% 6.7% Skewness Kurtosis VaR (95%) 6.7% 10.5% VaR (99%) 10.8% 16.0% Conditional VaR (95%) 10.1% 11.6% Conditional VaR (99%) 13.8% 22.5% Average Negative Return 3.41% 5.10% Average Positive Return 3.39% 5.20% Campbell R. Harvey

17 Diversification Benefits Reduced Correlations have dramatically increased Emerging Markets Have Become More Correlated with Developed Markets Correlation (5 Year Trailing) Source: MSCI 0.0 Campbell R. Harvey

18 Diversification Benefits Reduced Correlations tell only part of the story Alternative Measures of Diversification Monthly Returns Average Monthly Returns Median Annual Returns Average Annual Returns Median DM Return when DM Return is Negative 3.41% 2.40% 14.48% 14.72% EM Return when DM is Negative 3.42% 2.63% 15.51% 12.57% DM Return when DM Return is Positive 3.39% 2.80% 18.61% 18.08% EM Return when DM is Positive 3.99% 3.48% 28.25% 29.25% Source: MSCI Campbell R. Harvey

19 Market Integration Why have correlations increased? Source: Bekaert, Harvey and Lundblad (2005) Open Capital Account Investable Equity Trade Openness Open Equity Market Campbell R. Harvey

20 Market Integration Still sharp differences in governance Developed Markets Enforcing Contracts Rule of Law Regulatory quality Voice and accountability Property rights Political Stability and absence of violence/ terrorism Control of corruption Australia DM High High High High High High High France DM High High High High High Medium High Germany DM High High High High High Medium High Hong Kong DM High High High Medium High High High Japan DM High High High High High High High Norway DM High High High High High High High United Kingdom DM High High High High High Medium High United States DM High High High High High Medium High Emerging Markets Brazil EM High Medium Medium Medium Medium Medium Medium China EM High Medium Medium Low Low Low Medium Czech Republic EM Medium High High High High High Medium Hungary EM High Medium High Medium Medium High Medium India EM Low Medium Medium Medium Medium Low Medium Mexico EM High Medium Medium Medium Medium Low Low Korea, South EM High High High Medium Medium Medium Medium Russia EM High Low Medium Low Low Low Low Source: MSCI, World Bank (2015 WGI), Rank Doing Business, Heritage Foundation. Countries are assigned a rank of High if they have an MSCI ESG score below 3.0 for Government Risk Exposures (the first three columns) or above 7.0 for Governance Risk Management (the second four columns). A rank of Low is assigned for scores above 7.0 for Government Risk Exposures and below 3.0 for Governance Risk Management. Scores between 3.0 and 7.0 inclusive are assigned a rank of Medium. Campbell R. Harvey

21 Market Integration Convergence and divergence in valuation Price to Earnings Ratios Price to Earnings Source: MSCI MSCI Emerging Markets MSCI World Campbell R. Harvey

22 Market Integration Aggregate PEs do not tell the whole story Market segmentation measure 14% 12% 10% Emerging markets 8% 6% 4% 2% Developed markets 0% Source: Bekaert, Harvey, Lundblad and Siegel (2010) Campbell R. Harvey

23 Market Integration Aggregate PEs do not tell the whole story Market segmentation measure 14% 12% 10% 8% Emerging markets 6% 4% 2% Developed markets Segmentation within United States 0% Source: Bekaert, Harvey, Lundblad and Siegel (2010) Campbell R. Harvey

24 Allocations to EM What about the perspective of a long term investor? Are there risk premia to be harvested from EM investment? Campbell R. Harvey

25 Allocations to EM 1. Segmentation EM markets are still not fully integrated. Both governance issues as well as political risk can lead to risk premia Campbell R. Harvey

26 Allocations to EM 2. Liquidity Well known that illiquidity is rewarded with a risk premium Estimated Beta to GEM2 Liquidity Factor Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 MSCI World MSCI EM Campbell R. Harvey

27 Allocations to EM 3. Skew Conditional VaR (99%) is almost double DM MSCI World MSCI EM Average Monthly Return 0.7% 1.2% Standard Deviation 4.4% 6.9% Skewness Kurtosis VaR (95%) 7.4% 10.6% VaR (99%) 10.9% 16.3% Conditional VaR (95%) 10.1% 11.7% Conditional VaR (99%) 13.8% 22.5% Average Negative Return 3.5% 5.3% Average Positive Return 3.5% 5.3% Campbell R. Harvey

28 Allocations to EM 4. Growth Ops Excess returns may be correlated with future GDP growth 5 year Average Annual Excess Returns to S&P EM and MSCI EM % 1% 2% 3% 4% 5% 6% 7% 8% year Average Real GDP Growth for EM Countries Campbell R. Harvey

29 Allocations to EM 5. Selection Greater crosssectional dispersion means more selection opportunities both among individual names as well as countries 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Cross Sectional Volatility (CSV) DM Total CSV EM Total CSV Campbell R. Harvey

30 Answers? Has the risk profile of emerging markets changed? Yes. Traditional EMs less risky than 20 years ago but still are more risky than DMs Campbell R. Harvey

31 Answers? Are emerging markets more integrated today? Yes. But still a considerable way to go to be at the level of DMs Campbell R. Harvey

32 Answers? How much of a diversified global equity portfolio should be allocated to emerging markets? If your portfolio has less than 12.6% in EM Campbell R. Harvey

33 Answers? How much of a diversified global equity portfolio should be allocated to emerging markets? If your portfolio has less than 12.6% in EM you need to justify your bet I.e., why are you strategically underweighting EM? Note: CAPM would say 20% Campbell R. Harvey

34 Selected References "Emerging Equity Markets and Economic Development," with Geert Bekaert and Chris Lundblad, Journal of Development Economics, 2001, 66, "The Dynamics of Emerging Market Equity Flows," with Geert Bekaert and Robin Lumsdaine, Journal of International Money and Finance 2002, 21:3, "Dating the Integration of World Capital Markets," with Geert Bekaert and Robin Lumsdaine, Journal of Financial Economics, 2002, 65:2, "Market Integration and Contagion," with Geert Bekaert and Angela Ng, Journal of Business 78, 2005, "Does Financial Liberalization Spur Growth," with Geert Bekaert and Chris Lundblad, Journal of Financial Economics 77, 2005, Growth Volatility and Equity Market Liberalization," with Geert Bekaert and Chris Lundblad, Journal of International Money and Finance, 2006, 25:3, "Growth Opportunities and Market Integration," with Geert Bekaert, Chris Lundblad, and Stephan Siegel, Journal of Finance, 62, June 2007, "Liquidity and Expected Returns: Lessons from Emerging Markets," with Geert Bekaert and Chris Lundblad, Review of Financial Studies, 2007, 20:6, "Financial Openness and Productivity" with Geert Bekaert and Chris Lundblad, World Development, 2011, 39:1, "What Segments Equity Markets" with Geert Bekaert, Chris Lundblad, and Stephan Siegel, Review of Financial Studies, 2011, 24:12, Allocation to Emerging Markets in a Globally Diversified Portfolio Finansdepartementet, Government of Norway, Political Risk Spreads with Geert Bekaert, Chris Lundblad, and Stephan Siegel, Journal of International Business Studies, 2014, 45: Political Risk and International Valuation, with Geert Bekaert, Chris Lundblad, and Stephan Siegel. Journal of Corporate Finance, 2016, 37, Globalization and Asset Returns, with Geert Bekaert, Andrea Kiguel, and Xiaosheng Sandra Wang. Annual Review of Financial Economics, 2016, 8, Emerging Equity Markets in a Globalizing World, with Geert Bekaert. Working paper. Campbell R. Harvey