How to make the most from emerging markets

Spring is always an exciting time for financial markets. Year-end (or near year-end) company earnings are keeping investors on their toes, as everyone studies the numbers carefully trying to find the next big investment.

Whether companies are in the black or in the red, there is one common theme among them this year.

At the end of February, United States-based food maker H. J. Heinz Company said sales in emerging markets, particularly Asia, helped boost third-quarter revenue by 13 percent.

French specialty chemicals company Rhodia SA said exposure to emerging markets will continue to help improve profitability in 2010, after the company generated 45 percent of its sales from emerging markets last year.

Global hotel group Hyatt Hotels Corp recorded a loss in fourth quarter earnings, but stressed it is ready to capture in opportunities in emerging markets, where commercial activities are well supported by economic stimulus measures.

Corporations are focusing much of their attention on emerging markets in 2010, shifting key business and economic activities to these regions. This creates opportunities for investors to jump on the bandwagon, but some might be scratching their heads on how best to gain exposure to emerging markets.

A number of general points can be made based on the positives and negatives of the three main strategies: a global emerging markets approach, a regional approach and an individual country approach.

Global approach

There are a number of benefits for investors who adopt a global emerging markets approach.

First, asset allocation within the global emerging markets (GEM) universe is important. Investors who choose a manager with a balanced approach to GEM will certainly reap the benefits.

Managers who take active country and stock decisions, rather than the bottom-up approach, are better placed to add alpha from country exposure. Getting country allocation correct is a key source of return.

Second, a global approach ensures that the entire universe of emerging economies is considered.

The MSCI Emerging Markets index contains 22 countries and regions, 12 of which have an index weight of less than 2 percent, and seven have an index weight of less than 1 percent. Individually, these markets might not seem too important, but in aggregate they are a key part of the overall universe.

Moreover, a global manager will also be more likely to consider investing in frontier markets which are expected to become more important in the years ahead.

Third, such an approach brings significant diversification benefits. The trade off between risk and reward is generally much more attractive if a GEM approach is adopted. For example, taking money out of the EMEA or emerging Asian region and investing in GEMs can reduce risk and increase return.

Taking money out of Latin America and investing in GEMs can reduce returns, but significantly reduce risk.

The main negative in adopting a global approach is that the investor has less control over the structural overweight or underweight positions to regions or countries. Although combining a global approach with a regional or country strategy can solve this to a certain extent, it also introduces an additional level of complexity in terms of monitoring net exposure to each region and country.

Regional approach

The main benefit of using a regional approach to emerging markets is to increase the control over the asset allocation decision without losing exposure to the smaller economies in the overall emerging markets benchmark. However, this is likely to require more investment expertise and involve higher costs if the investor brings in a professional.

In addition, although a regional approach helps the investor establish strategic exposure to the various regions, this may not necessarily equate to emphasizing desired thematic tilts. For example, a high level of dispersion within regions suggests that country returns, even within the same region, are not always driven by common factors.

Putting this into perspective, Russia is a clear beneficiary of rising energy prices, whereas Turkey does better when energy prices are falling. In our opinion, the level of control over exposure to particular themes via a regional approach is therefore likely to be overstated.

Country approach

This approach provides the most control over asset allocation, and exposure can be fine-tuned accordingly. However, it can easily lead to a focus on the larger emerging economies with the smaller economies and the frontier markets being overlooked.

Moreover, it will almost certainly require a significant investment in professional advice in order to make informed country allocation decisions within the emerging market universe.

Finally, the cost of this approach is likely to be relatively high compared to a global or regional strategy; both in terms of hiring expertise and managing the strategy.

Rebalancing within a country approach is likely to be less efficient and more costly when moving assets between managers than within a global strategy. In reality, if a country-based approach is to be successful the investor would really need to internalize the entire management of the assets, including stock selection.

In conclusion, we believe the investor should leave the regional/country allocation decision within GEMs to the professionals. Country allocation has the potential to add substantial alpha. In our opinion an asset manager with significant emerging market resources and expertise is much better placed than a typical retail investor to generate returns from this decision.

The author is chief executive officer of Schroders Hong Kong.

(China Daily 03/25/2010 page17)