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
Acknowledgements Joint work with my long time collaborator, Geert Bekaert. Emerging Equity Markets in a Globalizing World http://ssrn.com/abstract=2344817 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 2017 2
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 2017 3
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 2017 4
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 2017 5
Developing Emerging Markets 1987: US + Japan = 43.8% of world GDP 1987: China 2.0% Rank 1987 2015 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 2016. Data for 2015 is as of April 2016. Campbell R. Harvey 2017 6
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 2017 7
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 2017 8
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 2017 9
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 2017 10
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 2017 11
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 2017 12
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 2015 4.25% 7.13% January 1988 to December 2000 5.55% 6.83% January 2001 to December 2015 3.13% 7.38% Annualized Standard Deviation January 1988 to December 2015 14.95% 23.23% January 1988 to December 2000 13.91% 23.76% January 2001 to December 2015 15.79% 22.81% Sharpe Ratios (annualized returns) January 1988 to December 2015 0.28 0.31 January 1988 to December 2000 0.40 0.29 January 2001 to December 2015 0.20 0.32 Beta vs. ACWI January 1988 to December 2015 1.16 January 1988 to December 2000 1.03 January 2001 to December 2015 1.25 Alpha (annualized returns) January 1988 to December 2015 3.52% January 1988 to December 2000 3.15% January 2001 to December 2015 4.15% 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 2017 13 Note: Geometric average is used for average annualized returns above. Source: MSCI
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 2017 14
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 2017 15
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 0.6 0.6 Kurtosis 1.4 1.7 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 2017 16
Diversification Benefits Reduced Correlations have dramatically increased Emerging Markets Have Become More Correlated with Developed Markets 1.0 0.9 0.8 Correlation (5 Year Trailing) 0.7 0.6 0.5 0.4 0.3 0.2 0.1 Source: MSCI 0.0 Campbell R. Harvey 2017 17
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 2017 18
Market Integration Why have correlations increased? 1.0 0.8 0.6 0.4 0.2 0.0 1973 Source: Bekaert, Harvey and Lundblad (2005) Open Capital Account Investable Equity Trade Openness Open Equity Market 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 Campbell R. Harvey 2017 19
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 2017 20
Market Integration Convergence and divergence in valuation Price to Earnings Ratios 40 35 30 Price to Earnings 25 20 15 10 5 0 Source: MSCI MSCI Emerging Markets MSCI World Campbell R. Harvey 2017 21
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 2017 22
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 2017 23
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 2017 24
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 2017 25
Allocations to EM 2. Liquidity Well known that illiquidity is rewarded with a risk premium Estimated Beta to GEM2 Liquidity Factor 12 10 8 6 4 2 0 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 2017 26
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 0.6 0.6 Kurtosis 1.4 1.7 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 2017 27
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 0.3 0.25 0.2 0.15 0.1 0.05 0 0% 1% 2% 3% 4% 5% 6% 7% 8% 0.05 0.1 0.15 0.2 5 year Average Real GDP Growth for EM Countries Campbell R. Harvey 2017 28
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 2017 29
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 2017 30
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 2017 31
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 2017 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 you need to justify your bet I.e., why are you strategically underweighting EM? Note: CAPM would say 20% Campbell R. Harvey 2017 33
Selected References "Emerging Equity Markets and Economic Development," with Geert Bekaert and Chris Lundblad, Journal of Development Economics, 2001, 66, 465 504. "The Dynamics of Emerging Market Equity Flows," with Geert Bekaert and Robin Lumsdaine, Journal of International Money and Finance 2002, 21:3, 295 350. "Dating the Integration of World Capital Markets," with Geert Bekaert and Robin Lumsdaine, Journal of Financial Economics, 2002, 65:2, 203 249. "Market Integration and Contagion," with Geert Bekaert and Angela Ng, Journal of Business 78, 2005, 39 70. "Does Financial Liberalization Spur Growth," with Geert Bekaert and Chris Lundblad, Journal of Financial Economics 77, 2005, 3 56. Growth Volatility and Equity Market Liberalization," with Geert Bekaert and Chris Lundblad, Journal of International Money and Finance, 2006, 25:3, 370 403. "Growth Opportunities and Market Integration," with Geert Bekaert, Chris Lundblad, and Stephan Siegel, Journal of Finance, 62, June 2007, 1081 1138. "Liquidity and Expected Returns: Lessons from Emerging Markets," with Geert Bekaert and Chris Lundblad, Review of Financial Studies, 2007, 20:6, 1783 1832. "Financial Openness and Productivity" with Geert Bekaert and Chris Lundblad, World Development, 2011, 39:1, 1 19. "What Segments Equity Markets" with Geert Bekaert, Chris Lundblad, and Stephan Siegel, Review of Financial Studies, 2011, 24:12, 3841 3890. Allocation to Emerging Markets in a Globally Diversified Portfolio. 2012. Finansdepartementet, Government of Norway, http://www.regjeringen.no/pages/1934920/harvey.pdf Political Risk Spreads with Geert Bekaert, Chris Lundblad, and Stephan Siegel, Journal of International Business Studies, 2014, 45: 471 493. Political Risk and International Valuation, with Geert Bekaert, Chris Lundblad, and Stephan Siegel. Journal of Corporate Finance, 2016, 37, 1 23. Globalization and Asset Returns, with Geert Bekaert, Andrea Kiguel, and Xiaosheng Sandra Wang. Annual Review of Financial Economics, 2016, 8, 221 288 Emerging Equity Markets in a Globalizing World, with Geert Bekaert. Working paper. Campbell R. Harvey 2017 34 34