A new wave of investment is headed out of the United States, lured by high rates of economic growth in emerging markets, especially in Asia. Hope springs eternal, but unless investors are better informed they will meet systematic disappointments.
They have been disappointed before. In 1992 and 1993, U.S. investments in emerging markets rose dramatically. The triumph of capitalism evidenced by the fall of the Berlin Wall and the rise of market-oriented economies in Asia had led many countries to give free enterprise a real chance for the first time. Consultants and investment managers preaching the advantages of international diversification reached new heights of enthusiasm.
Many pension funds got on board only in early 1994. Sadly, since then the emerging stock markets as a group have sharply underperformed indexes of both developed international markets and the United States measured by the Morgan Stanley Capital International Europe Australasia Far East and the Standard & Poor's 500 Stock indexes.
Many U.S. investors have done even worse than the broad indexes, having concentrated in popular countries and concepts that proved overpriced.
The collapse of the Mexican peso was a flagrant example. Investors seduced by hype about the benefits of the North American Free Trade Agreement and the supposed modernity of the Mexican government's policies propped up not only the stock market but also the currency. Then, like the coyote in the Road Runner cartoon who runs off a cliff but stays momentarily suspended in midair, they looked down, saw reality, and plummeted.
The real opportunity
Emerging markets offer three significant opportunities through which U.S. savers can realistically hope to improve their returns.
First, these are risky markets that require better returns to attract capital. Truly emerging markets offer the higher specific risk and return characteristics of venture capital, but with a crucial difference. Because much of the risk of emerging markets centers on government attempts to both control and to open their local economies, the biggest risks are inherently local and therefore inherently diversifiable. This makes a portfolio of emerging markets far less risky to global investors than to local investors. The result can be venture capital profits without venture capital risks.
Second, properly selected emerging market investments are excellent diversification against the U.S. equity holdings that make up the bulk of U.S. investors' portfolios. During the stock market crash in October 1987, the market in Hong Kong was disaster, but the more truly emerging market in India actually went up. The latter kind of diversification can enable U.S. investors to achieve greater exposure to equity ownership in their overall portfolios without increasing portfolio volatility and thus further increase overall returns.
Third, as economist Joseph Schumpeter noted, the great source of profit, as opposed to mere rent on the use of capital, is innovation. The diffusion of free market "rules of the road" to countries previously held back economically by centralized or traditional thinking is a classic primary innovation in the Schumpeterian sense. Enormous wealth is being created. Think of the future as not only China, but also Brazil, Eastern Europe, India and Russia.
What goes wrong?
Why aren't U.S. investors happier with their emerging market experience? Typically, one or more members of any pension committee strongly believes emerging markets are too risky. However, the staff allows existing international managers to add emerging market exposures that tend to be overweighted in the most conventionally acceptable countries - countries that might even be in the EAFE index, like Malaysia, Singapore and Hong Kong. Within these countries, the concentration often will be on the largest, most conventional growth stories - "the rising middle class," or "world class management."
At some point, however, perhaps after emerging market returns have been especially compelling, the committee is convinced by staff and consultants to make specific emerging market allocations. Specialist managers are hired. Again, in an attempt to avoid being imprudent, there is a preference for hiring managers with either conventional regional experience or large overall emerging market assets under management.
What is the result? In 1995, emerging market returns generally were negative while developed markets had good results overall. However, we also know the annualized return of the International Finance Corp. Emerging Markets Index for the 10 years ended in 1994 was 16% - just about the same as for the developed country EAFE index. Even worse, far from capturing venture capital results, institutional investors who waited for social confirmation of their decisions lagged the long-term index performance. They bought at the highs created by the 1993 run-up and concentrated on already well-recognized growth stories.
An analysis of the IFC Emerging Markets Index, which is capitalization-weighted by country, shows that its return correlation with the S&P 500 Index is no lower than that of EAFE. Where are the benefits of diversification against the U.S. market?
The clue is in the 10-year behavior of an index of IFC emerging markets equal-weighted by country once a year. The return of this index averaged an astounding 33% a year and had a markedly lower correlation with the S&P 500.
Meeting the challenge
The formula for success in emerging markets is simple to state but more challenging to carry out:
Diversify broadly. Given all of the opportunities available today, there is no need to put more than about 10% of your money in any one emerging market. This will keep you underweighted in the most popular countries and force you toward superior financial engineering. An equal-weighted benchmark might be helpful.
Resist the urge to insure yourself against criticism. The best results will be earned in places where there is still significant political risk. You will have to make the judgment that some countries are too risky and illiquid for institutional investment, but be generous. After all, you can out-diversify the local investors, so you have a great advantage.
Don't try to do much short-term timing. The risks are too unpredictable and the transaction costs are too high. If the overall volatilities are too high to stay unemotional, try the old-fashioned remedy of dollar-cost averaging as you increase your emerging market commitment, rather than doing it all in one fell swoop after convincing a committee.
Look for innovation. This means early investment rather than after a "concept" has been shopped around. It might mean hiring an unusual investment manager. It might mean passive investment through equal-weighted indexing.
Although emerging markets already have attracted sizable assets from U.S. investors, the odds are that future flows will dwarf what we have seen so far.
Jarrod W. Wilcox is director of global investments at PanAgora Asset Management, Boston.
