Emerging market equities

November 22, 2010 Emerging market equities Jean-Pierre Talon, FSA, FICA

Introduction Focus of this presentation is to set out the rationale for a strategic bias toward emerging market equities Consider the following: Definition and structure of emerging markets Past performance Arguments for and against a strategic tilt toward emerging markets Conclusions 1

Definition and structure of emerging markets

Definition and structure of emerging markets Emerging markets is a widely used term but with no widely agreed definition Has been used to describe countries that have begun to undergo industrialisation and market-based reforms In an investment sense we tend to think of emerging markets as any/all of the following (amongst other things) Relatively immature markets Economies likely to experience stronger GDP growth over time Markets where political factors can have a significant impact MSCI use the following criteria Sustainability of economic development (GNI per capita threshold) Size and liquidity requirements Market accessibility criteria 3

Definition and structure of emerging markets MSCI classification 4

Definition and structure of emerging markets MSCI / FTSE / S&P While MSCI index is the most widely used by managers, FTSE and S&P/IFCI indices are also fairly common The construction of the 3 different indices is very similar at present there are only relatively minor constituent differences between the main index providers Clearly index constituents will change from time to time, and methodologies will differ to some extent such that country weights are slightly different 5

Definition and structure of emerging markets Country allocation Composition of emerging markets has changed over time Current breakdown of MSCI Emerging Markets index shown below MSCI Emerging Markets Breakdown Asia 55.7 Turkey 1.5 China 17.9 Poland 1.3 South Korea 12.7 Egypt 0.5 Taiwan 11.4 Czech Republic 0.4 MSCI Emerging Markets Index India 7.5 Hungary 0.6 Malaysia 2.7 Morocco 0.2 Indonesia 1.9 Thailand 1.3 Latin America 23.9 Asia EMEA Latin America Philippines 0.4 Brazil 16.9 Mexico 4.3 EMEA 20.4 Chile 1.4 South Africa 6.9 Colombia 0.6 Russia 6.3 Peru 0.6 Israel 2.8 6

Definition and structure of emerging markets Sector allocation 25.0 20.0 Percentage (%) 15.0 10.0 5.0 0.0 Financials Energy Utilities Info Tech Health Care Cons Staples Cons Disc Telecom Services Industrials Materials MSCI EM MSCI World 7

Definition and structure of emerging markets Frontier markets The term frontier markets is typically used to describe the smaller and less liquid subset of emerging markets Covers less developed parts of Eastern Europe, Asia, Middle East, and Latin America, as well as markets in Africa and the Caribbean These markets constitute close to 5% of global nominal GDP and represent 1% of the global market capitalisation Some of these economies have enjoyed stellar growth over recent years Frontier markets have typically been relatively inaccessible to institutional investors However restrictions on foreign ownership have reduced in many cases and liquidity has improved 8

Definition and structure of emerging markets Canadian Pension Funds Exposure The exposure to emerging markets equity can be obtained directly via an emerging markets equity mandate or indirectly via a foreign developed markets equity mandate The table below shows the direct exposure of Canadian pension funds to emerging markets equity: Fund Assets $0-$100M 0.2% $100M-$500M 0.3% $500M+ 0.8% % Allocation to EM Canadian pension funds are underweight to emerging markets equity Source : Mercer survey on Canadian pension funds asset allocation, 2010 9

Past performance: although not a guarantee of future results

Past performance Historically, emerging markets now constitute approximately13% of the MSCI AC World Index (from less than 2%, 20 years ago) 30 14% 25 12% 20 10% $ Trillion 15 8% 6% % Emerging Markets 10 4% 5 2% 0 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 0% Developed Emerging Proportion 11

Past performance Past performance of emerging markets over the last 22 years has significantly outpaced that over developed markets (by 5.7% p.a.) 100% 1,600 80% 1,100 60% 12 month return (%) 40% 20% 0% 600 100-400 Growth of $100-20% -900-40% -60% 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10-1,400 Developed Emerging Cumulative Developed Cumulative Emerging 12

Past performance Greater volatility Rolling 5 year volatility Distribution of quarterly returns show a wider range (i.e. fatter tails) Volatility (% p.a.) 40.0% 30.0% 20.0% 10.0% 0.0% Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 MSCI Wrld GEM World Market Absolute Returns (Quarterly) Emerging Markets Absolute Returns (Quarterly) Frequency 40 35 30 25 20 15 10 5 0-35 to -30-30 to -25-25 to -20-20 to 15-15 to -10-10 to -5-5 to 0 0 to 5 5 to 10 Absolute return (%) 10 to 15 15 to 20 20 to 25 25 to 30 30 to 35 Frequency 40 35 30 25 20 15 10 5 0-35 to -30-30 to -25-25 to -20-20 to 15-15 to -10-10 to -5-5 to 0 0 to 5 5 to 10 Absolute return (%) 10 to 15 15 to 20 20 to 25 25 to 30 30 to 35 13

Arguments in favour of a bias towards emerging markets

Arguments in favour of a bias towards emerging markets Engine of growth for global economy i.e. global importance Attractive investment opportunities for companies located therein Demographic factors Population growth Population ageing Emergence of a consumption oriented middle-class Enormous pool of cheap labour Stronger fiscal positions 15

Arguments in favour of a bias towards emerging markets Global importance Share of world GDP Growth (Blended weights, %) 70% 60% 50% 40% 30% 20% 10% 0% 1961 1968 1975 1982 1988 1995 2002 2008 Emerging share of global growth has grown from 20% to around 60% over last 50 years Source: UBS, Haver, IMF, World Bank. Data to December 2008 16

Arguments in favour of a bias towards emerging markets Global importance Emerging economies as % of total world 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Market cap (float adjusted) Market cap (full market) GDP Exports Energy consumption Foreign Exchange Reserves Land Mass Population Emerging Markets Developed Markets 17

Arguments in favour of a bias towards emerging markets Opportunities for companies It is likely that the corporate sector will continue to grow The opportunities for both new and existing companies located within emerging markets should exceed the opportunities available to companies focussed mainly on developed markets Developed market companies with a large base of consumers in emerging markets will also have the potential to benefit The range of opportunities open to the corporate sector in emerging economies should manifest itself in superior corporate earnings growth A specific allocation to emerging markets may be used to exploit this trend 18

Arguments in favour of a bias towards emerging markets Opportunities for companies Are emerging market companies simply using leverage to drive returns? Analysis by UBS (shown below) illustrates that corporate gearing ratios in the emerging world are significantly lower An up-tick in the level of leverage being used by corporate in the emerging world is likely to be positive for returns Corporate gearing ratio (%) 100 90 80 70 60 50 Overall EM Developed world 40 30 20 10 0 1992 1994 1996 1998 2000 2002 2004 2006 2008 19

Arguments in favour of a bias towards emerging markets Favourable demographics EM vs. Developed: Dependency Ratio (15-64 yrs old as % total, 1950-2050e) 70 70 Millions 4,500 Working age population, 15-64 cohort 68 66 64 62 60 58 56 54 52 68 66 64 62 60 58 56 54 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 50 52 0 1950 1960 1970 1980 1990 2000 2010E 2020E 2030E 2040E 2050E 1950 1960 1970 1980 1990 2000 2010E 2020E 2030E 2040E 2050E Emerging Developed (rhs) Emerging Developed Source: Morgan Stanley Research, United Nations World Population Prospects 2005 revision. Data as at September 2009. Source: UN, Morgan Stanley Research. Excludes the least developed sub-saharan African countries. E= UN Estimates. Data as at September 2009. 20 20

Arguments in favour of a bias towards emerging markets Potential for growth in domestic demand GDP per capita, $000s 70 60 50 40 30 20 10 0 Switzerland Netherlands France Canada United States Germany United Kingdom Singapore Italy Japan Hong Kong SAR Israel Czech Rep Korea Taiwan Hungary Poland Russia Turkey Chile Mexico Brazil Argentina Malaysia South Africa Colombia Peru Thailand China Morocco Indonesia Egypt Sri Lanka Philippines India Pakistan Emerging markets have low but fast growing GDP per capita Source: IMF 21

Arguments in favour of a bias towards emerging markets Potential for growth in domestic demand Share of emerging markets* exports GEM Exports by destination % 24 22 20 18 16 14 12 10 8 6 4 2 0 1992 1994 1996 1998 2000 2002 2004 2006 2008 % (of total developing countries exports) 70 65 60 55 50 45 40 35 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 U.S. China Export to developing countries Export to industrialized countries Reduced reliance on US growth Source: BCA Research April 2009. * Includes Brazil, Chile, Turkey, Taiwan, Korea, Thailand, Singapore, Malaysia, Indonesia, Philippines and India 22

Arguments in favour of a bias towards emerging markets Potential for growth in domestic demand 110% 100% 90% 80% 70% 60% 50% Mature Markets 84.0% Household debt as a % of GDP 40% 30% 20% 10% Emerging Europe 22.0% Latin America 11.7% Emerging Asia 30.2% 0% Germany USA UK Turkey Russia Czech Poland Hungary Croatia S. Africa Argentina Mexico Peru Colombia Brazil Chile Vietnam Philippines Indonesia India China Thailand S Korea Hong Kong Malaysia Taiwan Potential for rises in household leverage to further support consumption Source: IMF, Morgan Stanley Research. 2007 data. 23

Arguments in favour of a bias towards emerging markets Potential for growth in domestic demand Emerging economies exhibit: low and rising GDP per capita a reducing reliance on growth in the developed world, and relatively low levels of household leverage The increasing importance of growth in the domestic demand base in emerging markets should be supportive to: Corporate earnings growth for industries focussed on domestic consumption Sustained growth and a weaker link with developed markets Although this does not necessarily imply a decoupling from developed markets 24

Arguments in favour of a bias towards emerging markets Highly competitive labour costs 45 40 35 30 25 20 15 10 5 0 Hourly Labour Costs in US$, 2008 Germany Netherlands Sweden Switzerland Ireland Australia Italy France Canada UK USA Spain Japan Greece South Korea Czech Rep. Israel Poland Singapore Hungary Portugal Taiwan Hong Kong Brazil Venezuela Russia Chile Argentina Turkey Malaysia Mexico China Thailand Peru Philipines India Sri Lanka Source: EIU Estimates, December 2008 The labour cost advantage gives companies based in emerging markets a competitive advantage Developed market companies are forced to rely on improvements in productivity 25

Arguments in favour of a bias towards emerging markets Stronger fiscal positions (% of GDP) 400 350 300 250 200 150 100 50 0 Japan Netherlands USA Portugal UK Spain Greece France Germany Israel Egypt SouthKorea China Hungary Thailand South Africa India Brazil Turkey Poland Philippines Chile Czech Republic Indonesia Argentina Mexico Russia Private sector debt Public sector debt Source: IMF, CIA World Factbook, Eurostat, ING. Data to Dec 2007 26 26

Arguments in favour of a bias towards emerging markets Stronger fiscal positions Stronger government balance sheets provide the following benefits: Government ability to support and cushion their economies from recessions, mitigating to some extent the negative impact on the corporate sector Stronger fiscal positions are likely to be supportive for emerging market currencies (although there still remains the risk of short term volatility) 27

Arguments against a bias towards emerging markets

Arguments against a bias towards emerging markets Stronger GDP growth does not necessarily imply stronger stock market performance Volatility in emerging markets tends to be greater Political risks, currency crises, contagion across markets Correlation with developed markets has been increasing over time Diversification benefit does not seem as great as it has in the past Higher transaction costs and lower liquidity Lower liquidity itself leads to volatility 29

Arguments against a bias towards emerging markets Currency risk is difficult to hedge Company management arguably more variable in quality and less focussed on shareholder wealth creation Standards of investor protection trail those in developed markets SRI concerns Consider each of these in turn 30

Arguments against a bias towards emerging markets GDP growth and market performance Academic studies looking at many markets over long time periods show no positive correlation between per capita GDP growth and real stock returns J Ritter (2004) Dimson, Marsh and Staunton (2002) These studies argue that although consumers and workers may benefit from economic growth, owners of capital do not necessarily benefit In addition, anticipated returns deriving from stronger expected economic growth may be (more than) priced into the market 31

Arguments against a bias towards emerging markets Volatility and correlations The volatility in emerging markets tends to be greater Exposed to political risks, currency crises, contagion across markets The higher level of volatility is arguably part of the reason to expect an additional premium for investing in emerging markets The correlation with developed markets has been increasing over time so the diversification benefit does not seem as great as it has in the past Emerging markets still offer some diversification 32

Arguments against a bias towards emerging markets Volatility and correlations 40.0% Rolling 5 year volatility Volatility (% p.a.) 30.0% 20.0% 10.0% 0.0% Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 MSCI Wrld GEM Consistently higher levels of volatility experienced in emerging markets 33

Arguments against a bias towards emerging markets Volatility and correlations 1 0.8 Developed vs Emerging Correlation 0.6 0.4 0.2 0-0.2 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 From 2002 onwards, the rolling 5 year correlation between developed and emerging markets has been above 0.8 May or may not be indicative of a trend 34

Arguments against a bias towards emerging markets Transaction costs Higher transaction costs Lower liquidity While true this does not provide a strong argument against investing in emerging markets unless liquidity is a key concern 35

Arguments against a bias towards emerging markets Valuation Has the strong performance over recent years been driven by P/E expansion? The chart below shows a decomposition of emerging market returns over the last 15 years into dividends, earnings and valuation The driver of emerging market performance over this period has been earnings 1.5 1 0.5 Total 0-0.5 Sep-95 Sep-96 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Div E P/E -1-1.5 Source: Schroder 36

Arguments against a bias towards emerging markets Currency risk Currency risk is difficult to hedge Many commentators believe emerging market currencies to be undervalued on a PPP basis Factors in favour of EM currencies include: Balance of payments generally positive (and superior to developed world) Large foreign currency reserves available to support currencies Governments of EM economies have become more adept at controlling inflation Currencies in developed economies under pressure because of weakened economies Some active managers incorporate currency views within their approach However this should be kept under review and is clearly a risk to be aware of when investing in emerging markets 37

Arguments against a bias towards emerging markets Corporate governance concerns Corporate governance concerns include: quality of company management, investors protection and SRI issues (amongst other things) Positive changes in these areas have been occurring and are likely to continue to do so over time These issues contribute to part of the risk premium to be expected from emerging markets The use of skilful active managers should help mitigate these risks Mercer carried out a study for IFC (the private arm of the World Bank) looking at the incorporation of sustainable investment factors in the investment process used by emerging market equity managers Considerabe growth of sustainable investment processes Corporate governance is now a well-understood concept in emerging markets 38

Conclusions

Arguments for and against a bias towards emerging markets Conclusion In favour of a strategic overweight to emerging markets on the basis of the fundamental factors likely to support strong earnings growth for companies in these economies The main caveat to this is that consideration of market valuation at the point of making any (increase in) allocation to these markets will be important Be aware of increased risks and specific issues Any allocation will need to be considered within the context of the wider growth portfolio and as part of the overall strategy 40

Questions?