Insights. Understanding Emerging Markets. Executive Summary. Emerging market economies give rise to an array of new investment opportunities.

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1 Insights ascent.usbank.com Understanding Emerging Markets Emerging market economies give rise to an array of new investment opportunities. Executive Summary There has been an explosion of interest by investors in so-called emerging markets. It is estimated that in 2011 (through November 24, 2011), investors poured approximately $84.3 billion into emerging market stock funds, according to EPFR Global, which was on pace to top a record year in One factor explaining this heightened level of interest is a likely quest by investors both individuals and institutions to generate more competitive investment returns, while at the same time finding new and potentially effective ways to diversify their portfolios. Another factor may simply be that investors are intrigued by ways in which they can tap into emerging economies across the world that are experiencing significant growth at a rate far exceeding growth in developed markets. Whether because of favorable demographic developments such as a trend toward urbanization, booming exports driven by high levels of productivity, or other factors, wealth is being created at an astonishing pace in many emerging economies, giving rise to a vast array of new investment opportunities. Without question, investing in emerging markets entails some risks. Returns can be more volatile and since developing economies tend to be more sensitive to global economic growth, the potential negative impact on performance can be greater when unexpected events occur. Nevertheless, investors with a longer term time horizon have increasingly considered including exposure to emerging market investments as part of their overall asset allocation strategy. The world s emerging markets a developing opportunity The concept of emerging markets as an investment opportunity began to gain momentum after the end of the Cold War, in the early 1990s. Capitalism became the driving economic force in many countries that in prior decades had a more restrictive system in place or lacked investment capital to build on their economic potential. A common misperception is that emerging markets are primarily made up of smaller countries with equally small economies. In reality, some of the largest countries in the world, in terms of population and land mass, are classified as emerging markets today, and a few of these countries have huge economies. Please refer to important disclosures on page 7. 1

2 Nevertheless, the sizes of emerging economies vary widely. Three of the ten largest economies in the world China, Brazil and India qualify as emerging markets, as they are defined today. China is already the second largest economic power in the world, and from the perspective of Gross Domestic Product (GDP), is poised to overtake the U.S. as the world leader in the coming decades. By contrast, other countries that are classified as emerging markets, such as Hungary, Peru and the Philippines, have relatively small economies. So how does a country become classified as an emerging market? First, it is interesting to note that countries that fall under this definition can change from time to time as circumstances surrounding each nation s economy changes. There is also some debate about which countries should truly be considered emerging markets and which should not. However, the most widely accepted definition of emerging market countries is that used by the Morgan Stanley Capital International (MSCI) Emerging Equity Market Index. In designing this index, MSCI looks at three important characteristics that help distinguish an emerging market country from those that are considered developed markets. 1. Economic Development: The first characteristic relates to per capita income, and more specifically whether per capita income exceeds $12,196 the World Bank s high income threshold as of Countries above this threshold include the U.S., Canada, Great Britain, Germany, France and Japan. To provide a comparative example, per capita income in the U.S. is $47,184, while in China per capita income stands at $7,536 (based on World Bank data for ). 2. Market Accessibility: Some markets are inaccessible or closed entirely to foreign investors. Accordingly, emerging markets need to be available to foreign investment to be considered a legitimate part of the index. There must also be a reasonable degree of transparency about issuers of stocks and bonds, effective processes to deal with flow of capital in and out of the market, and an efficient operational and institutional framework. 3. Number, Size and Liquidity of Publicly-Traded Companies: A country must have a sufficient number of sizable companies with actively tradable shares so investment positions can be easily established and liquidated. Some markets may not qualify because, in the words of professionals, trading is simply too thin. Evolving markets As of the end of 2011, 21 countries were represented in MSCI s Emerging Markets Index. This benchmark was first created 25 years earlier as the first comprehensive and consistent investable benchmark for this component of equity markets. MSCI Emerging Market Index: Percent of allocation in various countries China 16.4% Mexico 4.6% Colombia 0.8% Korea 14.7% Malaysia 3.5% Philippines 0.7% Brazil 14.4% Indonesia 3.0% Peru 0.6% Taiwan 11.6% Thailand 1.8% Hungary 0.4% South Africa 7.9% Chile 1.5% Czech Republic 0.4% India 7.4% Poland 1.4% Egypt 0.3% Russia 6.4% Turkey 1.6% Morocco 0.0% Source: FactSet; data as of 9/30/11 Please refer to important disclosures on page 8. 2

3 Not so long ago, emerging markets were much less accessible to individual investors than is the case today. Insular and protective governments often allowed only direct investment by other governments or large institutions, and those dollars were often channeled through state-owned enterprises. Today however, emerging markets have entered the mainstream, allowing investors to tap into a wide range of investment opportunities in a variety of countries. Most of these opportunities are centered around aboveaverage economic growth the primary attraction to investors considering emerging markets. According to the International Monetary Fund (IMF), the average annual rate of growth in GDP for emerging economies is projected to be 6.25% from 2012 to By comparison, growth projections over the same period are 2.5% in the U.S., 1.5% in the eurozone and 0.6% in Japan. Underlying rapid growth favorable demographics Positive demographic trends are a key reason why growth potential is so strong in most emerging markets. Today, it is estimated that 60% of the world s population resides in the 21 MSCI Emerging Market countries. More compelling are trends underlying that number, including: Youthful economies: Nearly 70% of the population in these nations are of working age (between 15 and 64 years old) with the median age of a person living in one of the emerging economies just under 30 (source: United Nations Population Division). The percentage of working-age residents is expected to remain consistent in emerging markets until 2025, while by that time, only about six in ten Americans will be in that working age. The presence of a large working age population with relatively few dependents represents a demographic dividend that offers a window of opportunity for strong economic output. While the U.S. ages, emerging markets will likely maintain a younger, working-age population Working Age Population Median Age U.S. 66.9% 62.4% Emerging Markets* 68.2% 68.4% Weighted average based on population size. Source: United Nations, Department of Economic and Social Affairs (UNDESA) Population Division; *data reflects 2010 revision Booming urbanization: Historically, the movement of people from rural to urban areas has triggered powerful economic growth. This trend was evident in the U.S. from Civil War times, and accelerated dramatically after World War II. According to McKinsey & Company, 136 new cities all located in emerging market countries will enter into the ranks of the 600 largest cities worldwide and 100 of these cities will be located in China. As of 2010, 44.9% of the Chinese population lived in urban areas, according to the United Nations Population Division. The United States urban population was just over 45% of the total population in 1910 according to the U.S. Census Bureau. The total population of America in 1910 was roughly 92 million while the Chinese population in 2010 was 1.3 billion! That s the same urban percentage, but about 570 million more Chinese in cities 100 years later. Urbanization typically leads to productivity growth and the rise of new business to serve the denser population. The rise of a new middle class: The trends noted above and the economic opportunities associated with them have led to the development of an emerging middle class in these fast-growing nations. Millions of new consumers are entering the market for products and services created by companies positioned to capture the opportunity. For instance, home appliance sales in rural areas are up 66% year over year through November 2011, while the retail store Coach plans to increase their number of stores in China by 40% in Please refer to important disclosures on page 8. 3

4 Understanding Emerging Markets continued Many investors are attracted to the growth potential of emerging market stocks simply from an economic standpoint. However, another factor weighs in as well and that is the potential for above-average returns. Although demonstrating much more volatility, since 2001 emerging market stocks have significantly outperformed global stocks from developed markets (MSCI EAFE Index) and U.S. stocks (S&P 500 Index). It s important to remember that past performance is no guarantee of future results. Emerging market stocks have outperformed developed markets At the same time, the price paid for earnings in emerging markets was significantly lower through most of this period than the price paid for earnings in developed markets. Prices paid for earnings have not been extreme 24 Forward Price-To-Earnings Ratio Beyond demographics why invest in emerging markets? Emerging Markets Developed Markets Dec 2011 Source: BCA Research; data as of 12/30/11 Index level Total Return 400 Another potential benefit of including emerging markets in a portfolio is the diversification value it can provide. In recent years, this level of diversification has been difficult to find MSCI Emerging Markets 2007 MSCI EAFE Index S&P 500 Index Source: FactSet; data as of 9/30/11 The performance during a decade of returns that were far from spectacular for developed markets is the result of several underlying factors. One of the most notable is that since the new millennium, earnings of emerging market companies have grown exponentially. There was a pause during the financial crisis of 2008, but the dramatic rate of earnings growth quickly resumed. Earnings from emerging market companies have skyrocketed Earnings Per Share (January 1995=100) 600 As the following table shows, emerging market stocks have historically provided differentiated performance compared to other important asset classes. Along with providing the impetus for growth in a long-term portfolio, including emerging market stocks as part of an asset mix may help improve the risk-reward ratio of a portfolio because of its inherent diversification benefits Emerging Markets Developed Markets 2010 Asset classes with a low correlation to each other tend to perform differently in different market cycles. For example, in periods when U.S. stocks are struggling, assets like gold or real estate may be performing better. That s because the performance of stocks and hard assets (gold, real estate) is not closely correlated over various market cycles. Asset classes that are perfectly correlated, moving in sync with each other at most times, have a correlation co-efficient (value) of 1.0 or close to it. The lower the number, the less two asset classes are correlated. Dec 2011 Source: BCA Research; data as of 12/30/11 Please refer to important disclosures on page 8. 4

5 Correlation of emerging markets to other major asset classes International Equity (Developed Markets) 0.70 U.S. Equity (Large-Cap Stocks) 0.69 U.S. Real Estate 0.45 Commodities 0.11 U.S. Fixed Income (0.25) Source: FactSet; data period is 1/01/90 9/30/11 International equity is measured by the MSCI EAFE. U.S. equity is based on the S&P 500. U.S. real estate is based on the Wilshire REIT Index. Commodities are based on the S&P GSCI Index. Fixed Income is based on the Barclay s Aggregate bond index. It is not possible to invest directly in an index. The realities of risk in emerging markets While the reward potential for emerging market investing is impressive, it can t be viewed as the silver bullet for an investor. Just as with any asset that offers prospects for significant returns, risk factors associated with the asset class, on its own, must be considered as well. The three most relevant risks to most investors are: 1. Economic instability: By name alone, it is clear that emerging markets are countries where economies are still developing. In most emerging markets, past or present, you will find a weakness in their institutional framework or a struggle with transition of power. This is in contrast to large, established markets like the U.S., Japan and Germany that are considered developed markets. Because emerging market countries have less-established economies, they could be more susceptible to external events. Specifically, most emerging economies are reliant on exports to developed nations so economic problems in export markets could have a tremendous impact on economic performance of emerging markets. 2. Susceptibility to crises: Newer economies are subject to crises that may not typically be an issue in developed markets. Events that have been centered in emerging markets and have occurred in recent times include: Mexican Peso crisis of 1994 Asian Financial crisis of 1997, originating in Thailand Russian default of 1998 In each of these instances, markets were rattled as fiscal imbalances forced a rapid devaluation of currencies of these nations. Each required some form of bailout from the IMF and selected nations. The performance of the MSCI Emerging Markets Index suffered a notable setback with each of these events. It is hard to think of any economy that successfully transitioned from emerging to developed without several major financial crises along the way. 3. Over-concentration of companies or industries: Many emerging market economies are built upon the strength of a small number of companies or industries. Highly concentrated investments in individual securities or sectors carry a degree of risk, should the security or sector suffer a significant loss of value. For example, more than half of Taiwan s economy is made up of technology companies. About one-third of China s economy consists of financial firms, driven by China s large, state-owned banks. This level of concentration represents a notable risk to investors who are considering emerging markets. One way to potentially mitigate that risk may be to invest in the ishares Emerging Markets Index (EEM). It is made up of more than 800 stocks from 21 countries. No single company position represents more than 3.1% of the EEM index, and from a sector perspective, the EEM index is better diversified than may be the case with individual countries. However, four sectors Financials, Energy, Materials, and Information Technology comprise nearly two-thirds of the value of the EEM index (as of the end of 2011). U.S. investors considering emerging markets for their portfolio need to be prepared for dramatic, short-term fluctuations in value. A long-term holding period should be a requirement for emerging market investors. Please refer to important disclosures on page 8. 5

6 Beyond emerging markets exploring frontier market opportunities Smaller countries that are in the infant stages of developing a capitalist-driven economy have been dubbed frontier markets in the investment marketplace. They are characterized by a higher risk premium due to illiquidity and greater economic, political and social risks. While these markets do not have an extensive track record, they seem to offer a combination of strong return potential, significant risk and notable diversification value (low correlation with more popular asset classes) for a broad portfolio. Some of these frontier markets will evolve into emerging markets over a period of years. MSCI launched a frontier markets index in 2007 composed of 25 country markets. Interest may increase as managers specializing in these markets demonstrate the ability to take advantage of the opportunities made available by companies represented in the frontier index. Americas Argentina MSCI Frontier Markets (FM) Index Central & Eastern Europe & CIS* Bulgaria Croatia Estonia Kazakhstan Lithuania Romania Serbia Slovenia Ukraine Source: MSCI, Inc.; data as of 9/30/11 *Commonwealth of Independent States Africa Middle East Asia Kenya Mauritius Nigeria Tunisia Bahrain Jordan Kuwait Lebanon Oman Oatar Bangladash Pakistan Sri Lanka Vietnam United Arab Emirates Three ways to access emerging markets as an investor Because securities markets of emerging countries are not always well established or easily accessed, investors who want to leverage the potential of emerging markets in their portfolio may consider one of three alternatives: 1. Owning individual stocks of multinational companies: Large, multinational firms with a global presence have diversified into emerging markets. Many of these countries have become low-cost producers and have a new emerging middle class. It is important to carefully research the exposure that individual multinational companies have to emerging markets, as it may only represent a small portion of their revenue. At best, this provides only indirect access to emerging market opportunities. 2. Index Funds/ETFs/ETNs: Passively managed index mutual funds, exchange traded funds (ETFs) and exchange traded notes (ETNs for fixed income investors) provide a low-cost way to access emerging markets. The major advantage is that investors know they are fully invested in a specific country or a broad market index that represents the emerging market opportunity. This allows a pure way to add emerging market diversification to an asset allocation strategy. 3. Actively Managed Accounts/Mutual Funds: Active managers also have the ability to make a pure play into emerging markets, but seek to outperform the benchmark index by using a selective approach in choosing countries, regions, sectors or individual securities within those markets. The manager may try to mitigate negative market moves by reducing exposure to segments of the market perceived to offer less return potential or too much risk. The manager also can boost cash positions to negate some of the impact of a down market. Using this approach, it is critical to perform due diligence in selecting a quality manager with a strong track record. Please refer to important disclosures on page 8. 6

7 Conclusion Emerging market investments may potentially improve the risk-reward ratio within a portfolio. It is difficult to overstate the growing importance that emerging markets play in today s investment world. Serious, long-term investors who have not yet capitalized on the opportunity in emerging market equities may want to at least consider doing so. Individuals need to be aware of the realities of an investment in emerging markets. It is among the most volatile asset classes on the market and subject to dramatic price swings with little notice. However, in recent times, emerging market stocks have demonstrated a significant performance advantage over other types of equity investments. This is an apparent reflection of the rapid economic growth among many developing nations. Because of the low correlations emerging market stocks have with many standard asset classes, they may help effectively diversify a portfolio. In this way, investors have the potential to benefit from the opportunity for potentially more competitive returns while attempting to limit the overall risk of a portfolio. Please refer to important disclosures on page 8. 7

8 Important DISCLOSURES Not a Deposit Not FDIC Insured May Lose Value Not Bank Guaranteed Not Insured by Any Federal Government Agency This information was developed January, 2012 and represents the opinion of U.S. Bank. It does not constitute investment advice and is issued without regard to specific investment objectives or the financial situation of any particular individual. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts will come to pass. The information presented is for discussion purposes only and is not intended to serve as a recommendation or solicitation for the purchase or sale of any type of security. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not affiliated with any of the organizations or firms mentioned in this publication and is not responsible for and does guarantee the products, services or performance of its affiliates or third-party providers. Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio. Hedged equity and hedged fixed income investment strategies are typically available via hedge funds which may not be appropriate for all clients due to the speculative nature and high degree of risk involved in these investments. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets. The MSCI EAFE Index is an unmanaged index that includes approximately 1,000 companies representing the stock markets of 21 countries in Europe, Australasia and the Far East (EAFE). The MSCI Frontier Markets Indices provide broad representation of the large-, mid-, and small-cap equity opportunity set across 31 frontier market countries. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. The S&P GSCI Index is a composite index of commodity sector returns that is broadly diversified cross the spectrum of commodities. Barclays Capital Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities, and commercial mortgagebacked securities. The Wilshire U.S. REIT Index measures U.S. publicly-traded Real Estate Investment Trusts. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Alternative investments very often use speculative investment and trading strategies. There is no guarantee the investment program will be successful. Alternative investments may not be suitable for every investor, even if the investor does meet the financial requirements. It is important for investors to consult with their investment professional prior to investment in these investments. Exchange-traded funds (ETFs) are baskets of securities that are traded on an exchange like individual stocks at negotiated prices and are not individually redeemable. Shares of ETFs may trade at a premium or a discount to the net asset value of the underlying securities. Exchange-traded notes (ETNs) are unsecured promises by the issuer to pay a rate of return that is tied to the change in the value of an underlying index. Not only are ETN holders exposed to market risk, they are subject to credit (counterparty) risk. Much like ETFs, ETNs can be purchased and sold throughout the trading day, however there is no guarantee that the market price of an ETN during the trading day will reflect the change of the underlying index or commodity, thus opening the door for tracking error. Mutual fund investing involves risk; principal loss is possible. Investing in certain funds involves special risks, such as those related to investments in small- and mid-capitalization stocks, foreign, debt, and high-yield securities, and funds that focus their investments in a particular industry, or employ a long-short strategy. Please refer to the fund prospectus for additional details pertaining to these risks. U.S. Bank may enter into agreements with non-proprietary mutual funds or their service providers whereby U.S. Bank provides shareholder services and/or sub-transfer agency, custodial and other administrative support services and receives compensation for these services. Compensation received by U.S. bank directly or indirectly from mutual funds does not increase fund fees and expenses beyond what is disclosed in the fund prospectuses. For more information, review the fund prospectus U.S. Bancorp (1/12) 8