Srinivas Maloor, Philippe Durand Srinivas.Maloor@ Philippe.Durand@ Introduction Developing countries, also known as the Emerging Markets (EM), have been growing at a significant pace, making them an area of focus for many institutional investment managers. While inflationary pressures have increased across some EM countries (notwithstanding a slowdown in global growth), these markets could still be volatile and subject to country risk. As these markets have matured, do they still provide an attractive opportunity set for the active manager? Using the Barra Global Equity Model (GEM2) and Barra Single Country models, we examine measures of volatility and dispersion to highlight the scope of the opportunity set and its corresponding risks. By applying these metrics to different attributes of the market, we can examine a range of management styles (fundamental stock selection, country focus, quantitative factor management and timing) to see potential risks and benefits. With Greater (Active) Opportunity Comes Greater Risk Despite a de-levering and slowing Europe, which may adversely impact EM trade flows, many emerging economies are nevertheless undergoing a secular move to increased economic wealth. Along with Frontier Markets (FM), they are the globe's fastest growing economies and are playing a key role in contributing to the world's trade growth. Trade among EM countries has increased dramatically in recent years, and after years of steadily improving economic conditions and high household savings rates, EM countries are no longer simply producers, but are now major consumers in the global economy. Today s stagnant growth and low interest rates in Developed Markets are prompting many institutional investors to re-examine their EM exposures. Stock Selection Strategy Equity markets are in a constant state of flux, reflecting actions by a variety of market participants with different objectives and constraints. This frequently produces inefficiencies in the evaluation of risk and Please refer to the disclaimer at the end of this document 1of 7
reward. While Developed Markets (DM) tend to adjust quickly to new information, EM equities tend to display lingering inefficiencies, 1 partly due to a lack of asset information transparency. The consensus is that EM countries are expected to have an increasingly large contribution to global growth in the coming years. Usually the BRIC nations 2 come to mind when investors think about investing in EM and many investors portfolios already have some allocation to BRIC equities. Figure 1: Proportion of Total CSV Explained by Common Factors. 3 45% 35% 25% 15% MSCI World MSCI EM Cross-sectional volatility (CSV) measures the return dispersion of a universe of securities. Put another way, it measures whether stocks are moving together or are diverging, providing a guide to investors on the level of active risk and alpha potential in an equity market. As CSV increases, the opportunity to outperform (or underperform) the market increases as well. Both portfolio managers and institutional investors must take current levels of CSV into account. Managers evaluate CSV to make sure that the risk profile of their portfolio is appropriate for their objectives; investors use CSV to assess performance records and make informed investment decisions. The CSV for a point in time will always be greater than zero unless all the returns are equal. The (excess) return dispersion or CSV in the market can be viewed as a means to analyze co-movement across a set of equity returns since the level of co-movement in returns is an important component in determining the appropriate level of portfolio diversification and in measuring the economic benefits of such diversification. As seen in Figure 1, the contribution to the total CSV from common factors is on a declining trend, pointing to an overall increase in the contribution to volatility from asset-specific 1 " Ranking efficiency for Emerging Markets, Chaos, Solitons & Fractals Vol. 22, Issue 2, Oct 2004, pp349-352. 2 The term BRIC is an acronym for the countries of Brazil, Russia, India and China, which are all deemed to be at a similar stage of economic development. 3 Using Barra Global Equity Model (GEM2), April 2012. Please refer to the disclaimer at the end of this document 2of 7
returns, thereby suggesting a higher potential for active management by superior stock-picking. A higher CSV provides active managers with greater opportunity to differentiate themselves in terms of stock selection, since winners and losers would have more disparate returns. Country Selection Strategy Many managers focus more on macroeconomic effects and the key to their investment strategy tends to be based on country selection. Examining the breakdown in the common factor CSV contributions owing to Styles, Countries, and Industries, as shown in Figure 2a, we see that the dominant form of common factor volatility arises from a country selection strategy, albeit on a slightly declining trend. Figure 2a: Percentage Contributions of Style, Country and Industry Factors to Total CSV (EM). 4 90% 80% 70% 60% 50% 0% Style Country Industry 4 Using Barra Global Equity Model (GEM2), April 2012. Please refer to the disclaimer at the end of this document 3of 7
Figure 2b: Percentage Contributions of Style, Country and Industry Factors to Total CSV (DM). 5 70% 60% 50% 0% Style Country Industry In a large portfolio where stock specific risk has been diversified away, there appears to be opportunity in country selection. While the proportion of country volatility has declined since 1997 as the development of Emerging Markets progressed, it is still the dominant source of volatility among the common factors. When compared with developed markets, the opportunity from EM country selection is quite clear. As the CSV decomposition depicted in Figure 2b suggests, it is less clear which factor set consistently drives common factor volatility in developed markets. For the active manager with skill in forecasting country performance, the volatility decomposition suggests a source of opportunistic active management in Emerging Markets. Style Selection Strategy For the quantitative investor who focuses more on styles, such as Momentum, 6 Figure 3 provides an interesting perspective: Momentum in each emerging market is not equivalent. Indeed there is limited evidence of BRIC markets behaving as a homogenous group. China's Momentum factor, for instance, is not following the trend established by the other three countries. After a decade of high growth, Chinese GDP has wavered over the last few quarters, and a World Bank report 7 suggests that Chinese growth could slow to 8.2 percent in 2012. Moreover, the Momentum factors in China and Russia seem to have experienced differential movement in the pre-crisis period. From the perspective of an opportunity set, the Momentum factor returns suggest that picking the right countries, including appropriate Momentum factor-timing, could be very important (see the positive return to Momentum after mid- 2009 in Figure 3). 5 Using Barra Global Equity Model (GEM2), April 2012. 6 Momentum is a global standardized factor determined by the relative performance of stocks during the recent past. 7 The Global Outlook in Summary, 2010-2014, The World Bank. Please refer to the disclaimer at the end of this document 4of 7
Figure 3: Momentum Factor Returns (Cumulative Returns, Using Brazil, Russia, India, and China Single Country Models). 50% 0% - - Brazil China Russia India This divergence among Momentum factors is reflected in the correlations as well (see Table 1), where we observe low correlations over the time period considered. This clearly points to the benefit of diversification that could be achieved with exposure to multiple Momentum factors. However, looking at the changes in correlations from pre to post-crisis periods, where the correlations moved rather dramatically, it is apparent that factor timing may also have a crucial role to play in a successful EM active strategy. Table 1: Correlations among Momentum Factor Returns. Correlations: Pre-Crisis <11/08 Correlations: Post-Crisis >11/08 China India Russia China India Russia Brazil 8% 11% 3% Brazil 31% 44% 43% Russia 7% -13% Russia 18% 69% India 38% India 43% Correlations: Entire Period China India Russia Brazil 15% 31% 24% Russia India 37% Please refer to the disclaimer at the end of this document 5of 7
Conclusion The investment picture in Emerging Markets is not clear: inflation in Brazil and India remains elevated and is weighing on their economies, while the slowdown of GDP growth in China has increasingly worried investors. The developed world is still suffering from large headwinds to growth from the damage inflicted by the financial crisis of 2008 and is currently struggling through the Euro crisis. Emerging Markets are playing an increasingly important role in the global economy, a trend that may see the EM accounting for an increasing share of the institutional investor s portfolio over the next few years. While our Cross Sectional Volatility plots suggest that there may be ample opportunity for stock pickers and country pickers alike, our results suggest that quantitative investors who focus on styles should be aware of possible increased correlations between factors. Please refer to the disclaimer at the end of this document 6of 7
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