An Evaluation Of Emerging Markets

The world has emerged faster than our understanding of world markets has emerged. Measured by purchasing power parity, China has the world’s second largest gross domestic product (GDP). More than three-quarters of the world’s electricity is consumed outside of the United States. The world’s largest producer and distributor of natural gas is a Russian concern called Gazprom. Global mergers and acquisitions in many industry sectors are characterized by enterprises in emerging markets becoming global leaders through serial acquisitions of competitors in other emerging and developed countries alike.

With the astounding growth that is happening in emerging markets, it is surprising that, as an asset class, they play a relatively small role in most U.S. investment portfolios — institutional and retail alike. A common rule of thumb is to cap emerging market exposure at 5% of a diversified portfolio’s risk-based assets. Unfortunately, this benchmark is arbitrarily derived and, as a result, it may be outdated. To understand this, we need to better understand what emerging markets really are, how their risk-return characteristics have evolved and where they belong in modern investment portfolios.

The Evolution of Global Markets Since the end of WWII, the international capital markets have gone through two distinct phases of evolution and are now in the early stages of a third phase.

The first phase could be called the age of globalism. This was an era of man-made creations to reconstruct the world after the destruction wrought by two world wars and a global depression. At the 1944 conference in Bretton Woods, New Hampshire, the International Monetary Fund (IMF) was established along with the Bretton Woods Agreement and the attendant infrastructure of international finance, facilitating 25 years of shared growth and prosperity.

The second phase, the age of globalization, came in the form of a disruptive tsunami unleashed with the marriage of Moore’s law to market liberalization. The geometrically explosive power of modern computing met the crumbling of the Bretton Woods fixed exchange rate system in the early 1970s, the rise of the eurobond market and the pioneering theories ofderivative securities to beget a perfect storm of new financial opportunities unconstrained by national borders and restrictive policies.

It was during this period that the phrase emerging markets gained popularity. Of course, there have always been emerging markets. The U.S. was once an emerging market itself, back in the 19th century, when England. France and other European countries were the dominant powers. The early post-war period saw the emergence of Japan from total devastation to a vibrant, high growth economy — the prototype the modern emerging market. (For more insight, see What Is An Emerging Market Economy? )

The globalization tsunami washed over places where markets had long been absent. In communist China, doctrine from Mao Zedong’s Little Red Book, a book of quotations from Zedong that was distributed among communist party members, gave way to a new more capitalist maxim that, To Get Rich is Glorious. In Eastern Europe. security walls crumbled and securities exchanges lit up for business. Portfolio and direct investment capital from the developed markets of North America, Europe and an emerged Japan raced around the globe in search of the next can’t-miss opportunity. Much of this capital, particularly the portfolio money, was not in it for the long-term but ready to repatriate to the home country when times got tough, such as in Thailand in 1997 and Russia in 1998.

Dawn of Global Capitalization This brings us to the third phase of global market evolution, the age of global capitalization. What’s different about this phase is that it is not about a bipolar world with developed markets on one end, emerging markets on the other and unidirectional capital flows from rich to poor. It’s about countries and regions mobilizing their own capital sources from increasingly wealthy business and consumer populations. In other words, capital locations are becoming more closely correlated with manufacturing, service and consumer locations. Consider the following: South Korea and Israel are part of the MSCI Emerging Markets Index, but have higher real per capita GDP than Greece. which is part of the MSCI EAFE Index of developed markets. The Czech Republic has a higher per capita GDP than Portugal. and so it goes. (For related reading, see The Importance Of Inflation And GDP and Explaining The World Through Macroeconomic Analysis .)

Around the world, new capital markets reflect both standards of global best practices and local flavor. Poland’s pension investment system, the tech-heavy Tel Aviv Stock Exchange and the Ukrainian corporate bond market are all distinct local markets with rapidly evolving legal, regulatory and procedural standards. Increasingly, what happens on these markets is not driven primarily by flavor-of-the-day decisions in London or New York, but rather the strategic actions of large companies in Russia, Brazil or China (for example) on the world stage.

Risk and Return If the lines between developed and emerging markets are blurring, we would expect to see evidence of this in risk-return profiles. Simply put, the traditional rationale for investing in emerging markets has been to dedicate a portion of a portfolio to assuming increased risk in pursuit of higher potential returns. One implication of global capitalization is that the risk-return boundaries would become less sharply delineated. The following chart provides an illustration of this. It measures the returns of selected markets on an annual average basis over a five-year period and the average risk, as measured by standard deviation, for the same period.