Balancing risk for maximum reward

While emerging markets are clearly at the risky end of the investment spectrum, the fact that many are growing apace means they should form an important part of any balanced portfolio.

The end of Soviet-style communism, the IT revolution and the effects of major changes in economic policy within China and India have combined to create an unprecedented situation within the global economy. An extra three billion people have been added to the global trading system, workers are on the move in a way not seen since the 19th century in search of better employment opportunities and capital moves seamlessly across borders.

Back in 1820, China had the world’s largest economy – accounting for nearly 29% of global GDP – while India accounted for about 16%. In contrast America accounted for only 1.8% of global GDP. Over the subsequent 150 years, these shares were reversed. However, China and India are making a comeback and, on current trends, are set to be the world’s second and third-largest economies within 20 years. In terms of GDP per head, China is where Japan was in the late 1960s and the current debate about the renminbi is reminiscent of an earlier debate about revaluation of the yen, when it too was pegged to the dollar.

High levels of economic growth have led to strong performance in most emerging equity markets, with the notable exception of China. The MSCI Emerging Markets index has outperformed the MSCI World index in each year since 2001. So far in 2005 emerging markets have returned seven percentage points more that the rest of the world. According to research from Morgan Stanley, profitability in emerging market companies (as measured by return on equity) crossed above the American level in late 2004 and has continued to rise since then, making it the region with the highest ROE globally. Compared with the situation in the 1990s, many emerging economies run large trade surpluses and also have extensive foreign exchange reserves. This should substantially reduce the risk of another crisis such as the one that hit Mexico in 1994 and Asia in 1997. Indeed it was the experience of the 1997 crisis that led Asian economies to reduce their reliance on foreign capital and build up substantial foreign exchange reserves.

However, in spite of the recent rise in share prices, emerging markets still trade at a large valuation discount to the rest of the world. The total size of the Indian equity market, for example, now accounts for 60% of Indian GDP, and this share has recently been as low as 35%. The global average is 80%. Arguably, with nominal GDP growth of 11% a year Indian equities are undervalued relative to other markets.

How should British investors respond to this phenomenon? Investing directly in these equity markets would be one approach. In the MSCI Emerging Markets index, South Korea and Taiwan together account for over a third of the index, with South Africa and Brazil accounting for about 10% each. China and India account for 7.5% and 6% respectively. More exotic destinations account for much smaller proportions of the index, for example Colombia 0.23%, Jordan 0.32% and Peru 0.5%. On a GDP-per-head basis Korea, Taiwan and Israel have moved above the $10,000 (5,760) threshold that normally separates emerging from mature equity markets. However, other issues such as political stability must also be taken into account. Given the political uncertainty in these three candidates for mature market status it is unlikely that they will lose their emerging market tag in the near future.

Attempting to invest in all these markets directly is, however, fraught with difficulties. In China, despite all that impressive economic growth, the equity market has halved over the past few years. This has been a direct consequence of too much capital chasing a limited number of profitable projects, meaning that in essence the equity market has become redundant as a source of finance for companies. In Russia the concerns relate mainly to property rights – are shareholders the legal owners of companies or can the government seize control of assets at any time? Other countries show a high degree of political uncertainty and opaque legal systems. Instead of a DIY approach, it is best to trust the experts and invest through one of the many emerging market debt or equity funds. These can range from country or industry-specific funds to general emerging market funds.

Basic portfolio theory suggests that it makes sense to invest in several asset classes to achieve the best trade-off between risk and reward. Emerging markets are definitely at the risky end of the investment spectrum and so it would be unwise to invest a large percentage of a portfolio in this area: there is too much stock-specific country and currency risk. However, given that many of these economies are set to grow faster that the global average, emerging market investments should form an important part of a balanced portfolio.