City of Fresno Retirement System Emerging Markets Educational Presentation December 16, 2013 Don Stracke, CFA, CAIA, Senior Consultant Allan Martin, Partner Tony Ferrara, Senior Analyst
Table of Contents What are emerging/frontier markets Why are we investing in emerging markets Case for small cap emerging market exposure Case for frontier market exposure Summary 2
Developed vs. Emerging
What constitutes an Emerging Market? The MSCI Market Classification Framework consists of the following three criteria: economic development, size, and liquidity as well as market accessibility. In order to be classified in a given investment universe, a country must meet the requirements of all three criteria as described in the table below. 1. Economic Development Criteria Frontier Emerging Developed Sustainability of economic development No requirement No requirement Country GNI per capita 25% above the World Bank high income threshold* for 3 consecutive years 2. Size and Liquidity Requirements Number of companies meeting the following Standard Index criteria 2 3 5 Company size (full market cap)** USD 505 mm USD 1010 mm USD 2020 mm Security size (float market cap)** USD 35 mm USD 505 mm USD 1010 mm Security liquidity 2.5% ATVR 15% ATVR 20% ATVR 3. Market Accessibility Criteria Openness to foreign ownership At least some Significant Very high Ease of capital inflows/outflows At least partial Significant Very high Efficiency of the operational framework Modest Good and tested Very high Stability of the instituitional framework Modest Modest Very high The economic development criterion is only used in determining the classification of Developed Markets while that distinction is not relevant between Emerging and Frontier Markets given the very wide variety of development levels within each of these two universes. The size and liquidity requirements are based on the minimum investability requirements for the MSCI Global Standard Indices. Emerging Markets country indices with fewer than three companies meeting the Emerging Markets size and liquidity requirements for four consecutive Semi-Annual Index Reviews will be reclassified as Frontier Markets. *High Income threshold for 2009: GNI per capita of USD 12,196 (World Bank, Atlas method) **Minimum in use for the May 2011 Semi-Annual Index Review, updated on a semi-annual basis Source: MSCI 4
Which Countries are Emerging Market Economies? 21 Markets Emerging Market Economies are generally defined by having low to mid GDP per capita or per capita income 23 Developed Countries 34 Frontier Countries Source: MSCI 5
Emerging Market Allocations Emerging markets comprise roughly 13% of global equity markets We believe clients are currently under allocated to emerging markets and should look to be at least market weighting Strategies benchmarked to the large cap or broader indices may not be exploiting the consumption opportunity Consider investing in emerging market small cap or domestic consumption linked strategies When increasing allocations there is an opportunity through EM small cap to better exploit the rise of the emerging market consumer Few managers in the space, opportunity to partner with top tier investment teams to launch commingled products at a fee discount. Frontier Markets may be used to compliment an existing well diversified emerging market allocation Markets are not well defined and strategies are capacity constrained and illiquid 6
Why are we investing in Emerging Markets
The Emerging Markets Lead World Real GDP Growth 2013 World Real GDP Growth Projections (%) Source: International Monetary Fund 8
EME Valuations are Historically Cheap Emerging Markets Forward P/E 30 MSCI EM + Std. Dev. - Std. Dev. 25 Mean 20 Fwd P/E 13.37 15 10 5 0 Source: MSCI 9
EME Valuations are Historically Cheap 3 Emerging Markets Price/Book 2.5 2 Price/Book 1.5 1 MSCI EM 0.5 0 + Std. Dev. - Std. Dev. Source: MSCI 10
2013 5-to-7 Year Return Forecasts Geometric Expected Return Asset Class 2012 2013 2013-2012 Cash 1.25% 0.75% -0.50% Treasuries 1.50% 1.00% -0.50% IG Corp Credit 4.50% 3.00% -1.50% MBS 3.25% 2.50% -0.75% Core Bonds* 2.88% 2.04% -0.84% TIPS 1.75% 1.50% -0.25% High-Yield Bonds 7.00% 5.00% -2.00% Bank Loans 5.00% 5.00% Global Bonds (Unhedged) 1.25% 0.75% -0.50% Global Bonds (Hedged) 1.49% 0.93% -0.56% EMD External 5.75% 4.00% -1.75% EMD Local Currency 6.75% 5.00% -1.75% Large Cap Equities 7.25% 6.75% -0.50% Small/Mid Cap Equities 7.50% 7.00% -0.50% Int'l Equities (Unhedged) 7.75% 7.75% Int'l Equities (Hedged) 8.00% 8.00% Emerging Int'l Equities 9.75% 9.75% Private Equity 9.75% 9.00% -0.75% Private Debt 9.50% 8.50% -1.00% Private Real Assets N/A 8.00% Real Estate 6.00% 6.00% Commodities 4.75% 5.00% 0.25% Hedge Funds Low Vol 5.50% 4.75% -0.75% Hedge Funds Mod Vol 7.25% 6.50% -0.75% * Core Bonds assumption based on market weighted blend of components of Aggregate Index (Treasuries, IG Corp Credit, and MBS). 11
Case for small cap
What is Emerging Market Small Cap? There is not one specific market cap cut off by country MSCI defines the universe as approximately the bottom 15 th percentile by market cap within each local market Liquidity and Free Float vary by market resulting in a different market cap cut off per country Down the cap spectrum you gain less exposure to SOE s (State Owned Enterprises) We define the universe loosely as below $3.5 billion in market cap The MSCI Emerging Markets Small Cap Index is the most widely accepted benchmark in the space (MSCI EM SC) The MSCI EM SC universe consists of roughly 2,000 securities, much larger than the MSCI EM universe roughly 800 securities Sell side research for the asset class is low and public information is not widely communicated This offers an opportunity for active management to add significant value The asset class offers a way to better exploit the emerging market consumption theme 13
Based off Current Trends Middle Class is expected to grow by 460 million people Source: GMO 14
Emerging Market Spending Growth Projected Growth in Disposable Income, 2010-2015 (% change) Source: Bloomberg News, Allianz, CLSA 15
The Consumption Story Has Worked 40% Cumulative Returns (12/31/2010-8/30/2013) 30% 20% 10% 0% -10% -20% MSCI EM Consumer Staples Consumer Disc Healthcare -30% Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Source: Bloomberg 16
Key Sector Exposure Differences Down the Cap Spectrum Down the cap spectrum there is greater exposure to the consumption theme, particularly the emerging market consumer Source: MSCI 17
Emerging Markets Equity Sizing the Market Index Characteristics Wtd Ave Market Cap (US$$m) MSCI EM MSCI EM Small Cap 31,138 740 Median Mkt Cap (US$$m) 3,781 316 Total # of Stocks 820 1,905 BRIC Allocation (Brazil, Russia, India, & China) 45% 30% Biggest Country China Taiwan Energy and Materials Allocation 27.4% 16.3% Consumption Based Sectors 17.2% 31.9% 18
EM Standard Deviation 6/30 Source: evestment 19
Median Excess Return by Asset Class When considering active management global equity, developed small cap, and emerging small cap appear to have the highest alpha potential Median Excess Manager Retrun 9% 1 Year 3 Year 5 Year EAFE Core 8% 7% 6% EAFE Value EAFE Growth EAFE Small Global Equity EM EM SC 5% 4% 3% 2% 1% 0% -1% Source: evestment as of 12/31/12 20
Case for frontier markets
What Are Frontier Markets? The simplest definition: countries that are not regarded as developed or emerging as defined by the investable indices For our purposes, markets must be investable Defined by characteristics: countries that are in the early stages of developing liquid equity markets and foreign exchange markets In some cases, low analyst coverage, and some market restrictions Defined by region: frontier markets are regionally focused on the Middle East, portions of Latin America, Eastern Europe, and Africa 22
Investment Thesis Frontier markets provide a diversified portfolio potential for excess return relative to emerging markets Provides an opportunity to gain a first mover advantage Capture the benefits of improving economies, rapidly growing markets, global integration, and increasing foreign investment The commodity boom reduced countries debt and generated individual wealth This wealth has slowly trickled down throughout the economy and has helped generate a rising middle class; the increased wealth of the individual has resulted in increased consumer spending as well as investing Frontier stocks are primarily driven by the local investor in addition to local economic and political dynamics These local drivers push inter-country correlations down (e.g., Venezuelan politics don t affect Vietnam's employment rate), which has the effect of reducing the systematic risk of the category as a whole As the frontier countries continue to experience economic growth and global integration, our view is that these correlations as well as volatility will increase Frontier Market investments should be long term and strategic in nature 23
Where Are Frontier Markets? 24
Investment Issues What is an appropriate benchmark? Short answer: there isn t one; better answer: some sort of blend between the two common benchmarks Two Major Indices: MSCI Frontier Market Index has roughly 60% within the Middle East of which roughly half is within Kuwait. S&P/IFC Frontier BMI Index is more diversified. Roughly 40% of the benchmark is allocated to the Middle East. South & Central America comprises roughly 25% of the index Of the two indices, the MSCI index is the more investable index Of the managers we reviewed, the majority use some sort of blended benchmark 25
Index Breakdown Source: Acadian, S&P, & MSCI GCC = Gulf Cooperation Council 26
What Are The Economics of Frontier Markets? Market Cap in Number Of Mils USD (June Population Agriculture GDP Estimated GDP in Mils IsoCountryName Companies 2013) MktCap/GDP (%) Below Poverty (%) Unemployment (%) (% of Labor) Growth (2013) USD (2010) Argentina 84 37,604 7.54% 30.0 7.2 9.1 2.8 498,698 Bahrain 44 22,767 81.02% NA 15.0 0.4 4.2 28,100 Bangladesh 252 25,911 19.17% 31.5 5.0 17.5 6.0 135,143 Botswana 24 5,140 28.15% 30.3 17.8 2.1 4.1 18,262 Bulgaria 178 5,769 10.60% 21.8 11.1 6.4 1.2 54,446 Colombia 42 194,408 50.05% 34.1 10.4 6.5 4.1 388,418 Croatia 186 32,568 54.18% 21.1 19.1 5.0 (0.2) 60,109 Cyprus 121 5,448 23.68% NA 11.9 2.4 (2.4) 23,006 Ecuador 8 3,665 4.21% 27.3 4.9 5.9 4.4 87,037 Estonia 18 2,809 11.63% 17.5 10.2 3.9 3.0 24,150 Ghana 26 5,034 11.79% 28.5 11.0 22.7 6.9 42,715 Ivory Coast 37 8,065 28.46% 42.0 NA 26.6 8.0 28,339 Jamaica 46 4,316 27.88% 16.5 14.3 6.4 0.6 15,477 Jordan 210 26,130 76.68% 14.2 12.5 3.1 3.3 34,076 Kazakhstan 36 48,416 22.61% 5.3 5.3 5.2 5.5 214,143 Kenya 61 22,012 47.36% 50.0 40.0 24.2 5.9 46,481 Kuwait 191 101,073 58.28% NA 2.2 0.3 1.1 173,438 Latvia 30 1,228 3.95% NA 14.3 5.1 4.2 31,115 Lebanon 11 5,140 11.72% 28.0 NA 4.6 2.0 43,842 Lithuania 33 4,301 9.37% 4.0 14.9 3.3 3.0 45,894 Mauritius 83 8,379 69.13% 8.0 8.1 4.4 3.7 12,121 Namibia 10 3,342 25.97% 55.8 51.2 7.4 4.2 12,868 Nigeria 172 86,663 30.54% 70.0 23.9 30.9 7.2 283,725 Oman 117 22,061 28.00% NA 15.0 1.0 4.2 78,788 Pakistan 465 54,411 22.77% 22.3 6.2 20.1 3.5 238,935 Panama 12 21,817 52.59% 26.0 4.4 3.8 9.0 41,485 Qatar 43 145,740 77.19% NA 0.5 0.1 5.2 188,812 Romania 936 17,826 9.53% 22.2 5.6 7.5 1.6 186,970 Saudi Arabia 156 398,471 53.44% NA 10.6 1.9 4.4 745,617 Slovakia 53 5,031 5.11% 21.0 13.6 3.8 1.4 98,456 Slovenia 54 6,166 13.20% 13.6 12.0 2.7 (2.0) 46,692 Sri Lanka 288 20,787 31.85% 8.9 5.2 11.1 6.3 65,266 Trinidad and Tobago 26 15,978 59.69% 17.0 5.6 0.3 2.0 26,768 Tunisia 63 9,225 18.64% 3.8 17.4 8.9 4.0 49,489 Ukraine 113 22,549 12.42% 24.1 7.5 10.2 0.2 181,595 United Arab Emirates 100 163,952 44.39% 19.5 2.4 0.8 3.1 369,364 Vietnam 789 43,802 28.09% 11.3 4.3 21.6 5.2 155,952 Zambia 18 3,446 14.93% 64.0 14.0 20.4 7.8 23,077 Source: Acadian 5,136 1,611,449 31.21% 25.5 12.1 8.4 3.6 27
Emerging Markets Equity FPL Managers as of September 30, 2013 Performance Related: Firm Name Excess Rtn - 5 Years Excess Rtn - 7 Years Std Dev - 5 Years Std Dev - 7 Years Sharpe - 5 Years Sharpe - 7 Years Info. Ratio - 5 Years Info. Ratio - 7 Years Acadian Asset Management LLC 1.68 1.09 29.34 29.49.30.20.50.30 City of London Investment Management Ltd..27 1.62 29.14 28.97.25.22.10.47 Dimensional Fund Advisors L.P..02.83 33.26 31.94.21.18.00.14 Eaton Vance Management.85 2.06 29.13 27.84.27.25.20.43 Mondrian Investment Partners Limited.17 1.15 25.47 25.12.28.24.03.18 Neuberger Berman 1.65 1.46 28.47 29.53.31.21.43.35 Polunin Capital Partners Limited 3.75 3.93 36.04 35.98.30.24.36.34 MSCI EM-ND --- --- 28.25 28.23.25.17 --- --- MSCI EM Small Cap-ND --- --- 33.06 32.94.37.21 --- --- MSCI Frontier Markets-ND --- --- 30.19 27.97 -.11 -.05 --- --- *MSCI EM-ND used for Info. Ratio calculation Market Cap Breakdown and Frontier Market Exposure: Firm Name Mkt Cap: % > 50 billion Mkt Cap: % 15-50 billion Mkt Cap: % 7.5-15 billion Mkt Cap: % 1.5-7.5 billion Mkt Cap: % 750-1.5 billion Mkt Cap: % 400-750 million Mkt Cap: % < 400 million Frontier Markets Acadian Asset Management LLC 20.85% 20.12% 24.93% 27.52% 1.79% 3.70% 1.10% 0% City of London Investment Management Ltd. 10.11% 17.99% 14.37% 34.46% 9.24% 6.31% 7.52% 10.9% Dimensional Fund Advisors L.P. 17.40% 14.43% 19.18% 29.28% 7.71% 5.44% 6.56% 0.0% Eaton Vance Management 8.53% 24.89% 21.06% 31.65% 7.63% 3.35% 2.90% 16.9% Mondrian Investment Partners Limited 31.65% 27.20% 27.26% 13.90% 0.00% 0.00% 0.00% 1.3% Neuberger Berman 23.88% 11.03% 14.60% 34.41% 13.25% 2.59% 0.24% 1.3% Polunin Capital Partners Limited 4.19% 8.61% 6.40% 34.28% 24.29% 14.75% 7.48% 13.7% *Frontier Markets exposure is estimated using available countries in evestment Alliance 28
Summary Consistent with our recommendations regarding GTAA managers, we believe that giving talented managers more tools increases the opportunity to add value NEPC does not believe that adding the ability for emerging markets managers to invest in small cap and frontier markets, within reason, dramatically increases the risk level of the investment In fact, the majority of our recommended managers incorporate some degree of small cap and frontier market exposure without incurring a dramatically higher volatility level Therefore, NEPC supports allowing managers the additional flexibility to invest in small cap and frontier markets within reason 29