EMERGING MARKETS MEMORANDUM (A0059005.DOC;1)
TO: South Carolina State Firefighters’ Association
FROM: S. Bart Valley, Cheryl R. Holland, Charles B. Flowers
DATE: June 22, 2007
SUBJECT: Emerging Markets Investment Recommendation
One of our duties in managing your portfolio is to consider a broad spectrum of potential asset classes for inclusion in your investment plan. As you know, our investment and management decisions with respect to individual assets or asset classes are evaluated not in isolation, but rather in the context of your portfolio as a whole and as a part of your overall investment strategy. We seek out asset classes whose inclusion should increase overall portfolio return, reduce overall portfolio risk, or a combination thereof.
Towards this end, we believe that the inclusion of emerging markets stocks in your portfolio will serve to enhance performance over the long-term. Emerging markets stocks are the equities of companies within emerging, or developing, international economies. Emerging markets form the tier of economies just below the developed economies. Emerging stock markets, generally in middle-income economies, are stock markets in transition—increasing in size, activity and level of sophistication. Taiwan, Mexico, Israel, Turkey and Brazil are all examples of the approximately 30 countries currently classified as emerging markets. The benefits of investing in these and other emerging countries include high expected returns, portfolio diversification, and exposure to a broader opportunity set of investments.
The most compelling reason for including emerging markets stocks in your portfolio is their potential for high rates of return. Reliable returns data on emerging markets is available back to January 1988, and from that point through year-end 2004, emerging market stocks have posted average annual returns of 17.45%, versus 12.39% for US large-capitalization stocks over the same period.[i] Emerging markets typically show trendline rates of economic growth above those of developed markets. This faster economic growth traditionally translates into higher growth in corporate earnings and hence higher equity market returns over time. As emerging economies successfully develop, they enjoy above-average long-term stock returns.
Other advantages that boost the performance of emerging markets over time include the upward pressure exerted by desire for improved standards of living, the possibility for rapid development through new technologies, competitive advantages such as low labor and resource costs, and an expanding consumer base. These factors in aggregate enhance the international competitiveness of these developing countries, benefiting corporate profit growth and equity market returns. As you can see in the chart on the following page, cumulative returns in emerging markets stocks have been quite exceptional when compared with traditional US stock and bond performance.[ii]
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In addition to their excess return potential, emerging markets stocks also bring significant diversification to the portfolio. The correlation between emerging markets stocks and US large-cap stocks from 1988 through 2004 has averaged only 0.54, meaning the addition of emerging markets stocks can actually serve to lower total portfolio volatility over time. Furthermore, emerging markets show only a 0.50 correlation to international developed country stocks, meaning they are providing a very different exposure than traditional international investments, further enhancing portfolio diversification. Because forces that drive markets differ from country to country, market returns also vary significantly from one emerging market country to another, bringing the opportunity for diversification within the asset class as well.
Emerging markets also provide an expanded set of attractive investment opportunities. Again, these are countries with absolute advantages such as cheap raw materials and low labor costs. Coupling these advantages with rapid diffusion of productivity-enhancing technology enables emerging market companies to increase returns on equity. Investors thus benefit from the ability to select among a broader set of strong-performing companies. These opportunities run from oil and mining companies to pharmaceutical companies to wireless telephone companies. Familiar emerging markets names include Samsung Electronics, Teva Pharmaceuticals, Petroleo Brasileiro and Wal-Mart de Mexico. There are a large number of world-class companies across these markets that are well positioned to benefit from rapidly growing and changing economies.
It is important to note that emerging markets investment do contain significant and unique risks. One of the most important is political risk. External conflicts, racial and national tensions, corruption and changing government policies can create political instability that can have negative effects on firms’ ability to generate earnings growth and stock market returns. Economic policies and/or reforms may fail at times, creating a challenging environment for corporate operations. Also important is the risk around the regulatory and operational environments in these emerging countries. The quality of market regulation, corporate governance and accounting standards is often below that of developed countries, making it more difficult to appropriately price securities.
These and other risk factors lead to a significant amount of volatility in emerging markets investments. Investors must understand that high rates of return are naturally accompanied by higher levels of risk. There will be periods when emerging markets investments significantly underperform other less risky assets in your portfolio. However, this volatility needs to be understood in the context of your larger portfolio. At a target 4% weighting, the higher rates of return and diversification benefits offered by emerging markets exposure should serve to enhance the long-term risk-return characteristics of your overall portfolio.
The vehicle we will be using to gain emerging markets exposure is the Dimensional Emerging Markets fund. This fund invests in a broadly diversified portfolio of more than 500 large company stocks across 15-20 top-tier developing nations. Since correlations among emerging markets are low, this diversification significantly reduces the volatility inherent in an emerging markets portfolio by reducing specific exposure to the aforementioned risks. As of year-end 2004, the Dimensional portfolio’s top five country weightings were Taiwan, Mexico, Korea, Israel and South Africa. Dimensional also attempts to reduce volatility by excluding certain emerging countries where risks may outweigh potential rewards. Information disseminated by the International Finance Corporation is an important tool in their consideration and approval of countries to be included in the portfolio.
The rationale for investing in emerging countries comes primarily from our expectations of superior long-term returns over time, and secondarily from the opportunity for risk reduction through diversification. Prudent investment in these countries that are experiencing substantial economic growth and rapid expansion of investment opportunities brings significant benefits to your investment portfolio. The inclusion of emerging markets investments will further enhance your portfolio’s ability to withstand ever-changing global conditions, and to thrive in a variety of economic and market scenarios.
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[i] Emerging markets measured by the DFA Emerging Markets Index. US large-cap stocks measured by the S&P 500 Index.
[ii] US large-cap measured by the S&P 500 Index. US small-cap measured by the CRSP 9-10 Index. Emerging markets measured by the DFA Emerging Markets Index. US Bonds measured by the Lehman Brothers Intermediate Government/Credit Index.
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