INVESTMENT RISK AND PERFORMANCE

by C. Mitchell Conover, CFA, CIPM, Gerald R. Jensen, CFA, and Robert R. Johnson, CFA

How Large Are the Benefits of Emerging Market Equities?

This comprehensive evaluation of the benefits of emerging market equities extends previous research by (1) evaluating a more complete sample, (2) using performance measures that account for asymmetrical return distributions, (3) considering emerging markets by region and individual country, (4) considering the influence the market environment has on the benefits of emerging market investments. We find that emerging markets allow investors to achieve lower risk, higher returns, and expanded riskreturn possibilitiesespecially when developed market investors need diversification the most.

revious research has documented a substantial benefit from investment allocations that include international equities. Recent research suggests, however, that the benefits of international investments in the developed markets may have diminished as the global financial markets have become more integrated. As a result, emerging markets have increasingly become the focus of researchers and investment professionals. The research reported here expands investor understanding of the diversification benefits offered by emerging market equities. Whereas most previous research considered emerging markets as a whole, we examine cross-country differences in the diversification benefits emerging markets offer. In addition, we consider the time-varying nature of the diversification benefits and investigate potential links between investment benefits and changes in financial market conditions. Finally, we apply performance measures that gauge the benefits offered by emerging market equities more accurately than previous measures could. The increased interconnectedness of the global economy, together with market liberalization in many developing countries, has facilitated the integration of emerging and developed markets. Relative to developed markets, however, emerging markets continue to display substantially more heterogeneity. The diverse nature of developing countries provides strong motivation to evaluate the merits

of their markets by geographical region and individual country as well as via broad emerging market indices. This article extends the research on emerging markets in the following specific ways. First, we relied on a dataset that includes more countries (20) than in previous research and a considerably longer time series. Our analysis spans more than three decades and encompasses the recent financial crisis as well as the intensified market liberalization that has occurred during the last two decades. The large sample helps to establish the robustness of our analysis and increases the confidence readers can have in our findings. Second, this study mitigates the upward return bias in many emerging market studies. Many past evaluations of the investment benefits to be garnered from emerging markets examined data only for countries in existence at the time of the study (i.e., they evaluated only the survivors, which are likely to have higher returns than nonsurvivors). Our set of 20 countries avoids this survivorship bias by containing winners and losers. Third, given the potential for non-normal return distributions in the emerging markets, we used performance measures that account for symmetrical return distributions and asymmetrical return distributions. Fourth, we constructed separate emerging market indices for Asia and Latin America in order to compare the relative benefits of investing in these regions. Given
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the substantial diversity in trade that occurs between developed countries and Asia versus trade between the developed countries and Latin America, we surmised that the investment benefits would differ between these areas. For example, a relatively high percentage of developed market imports from Latin America consist of commodities (raw materials), whereas developed market imports from Asia consist of a higher proportion of finished goods. Therefore, developments in the financial markets are likely to impact the equity markets of Asia and Latin America differently. In particular, inflationary pressures tend to elevate raw material prices, which can be beneficial for companies providing raw materials relative to finished goods manufacturers. Fifth, we examined whether the diversification benefit from emerging market equities varies based on conditions in U.S. financial markets. U.S. market conditions have been shown to be associated with developed market equity returns; for example, performance weakens during periods when inflationary concerns in the United States are elevated. In such environments, the U.S. Federal Reserve generally increases interest rates to control inflationary pressures. We wished to examine whether emerging markets are sufficiently segmented that they provide diversification benefits during these inflationary periods. Because the indicator of financial market conditions that we used was implemented on an ex ante basis, we could assess the practical implications for global portfolio performance. We found in our analyses that the majority of emerging markets provide the investor with higher U.S. dollar returns than is available from developed market indices. In 14 of the 20 emerging countries for the 19762010 period, the U.S. dollar return was higher than that available from a global portfolio of developed markets, as represented by the MSCI World Index. An equally weighted portfolio of emerging market indices provided a return that was 7.7% higher than that for the MSCI World on an annual basis. These high U.S. dollar returns were achieved despite pervasive losses from currency effects in 18 of the 20 emerging economies. For the GDPweighted emerging market index, the loss was 2.08% per month, or approximately 25% on an annual basis. These results highlight the importance of currency issues when investing in emerging markets. Furthermore, the crucial role that currency values play suggests that financial market conditions should be investigated when an investor is assessing the merits of emerging market equities.
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Examining standard deviations, we found the U.S. dollar risk in all 20 emerging countries to be higher than the risk of the U.S. equity index (4.43%). The same relationship was true for 19 of the 20 emerging countries when we examined local-currency risk, with the only exception being Portugal. For the 20 emerging countries, the average standard deviation based on U.S. dollars was 11.62%, and when calculated from local currency, was 11.40%. The risk was highest in Argentina, where the local-currency and U.S. dollar standard deviations were found to be 31.49% and 22.36%, respectively. When we examined emerging market indices, however, rather than the risk of individual countries, we found the risk to be substantially tempered; in U.S. dollar terms, it dropped to 5.19% for the equally weighted index and 6.19% for the GDP-weighted index. The dramatic drop in variation is consistent with the heterogeneity and relatively low inter-country correlation of the emerging market countries. Furthermore, the contribution of currency risk is surprisingly low in emerging markets. For the period studied, the contribution of currency risk was less than 1% in 15 of 20 emerging countries; it was lower for the equally weighted and GDP-weighted emerging market indices than when measured for the developed market EAFEC (Europe/Australasia/Far East plus Canada) and MSCI indices. Although emerging markets have high stand-alone risk, their low correlations with developed markets make them a beneficial addition to a developed market portfolio. The correlations for the individual emerging markets relative to the MSCI World in the study period were quite low; the maximum was 0.46 for Portugal. For 14 of the 20 countries, the correlation was less than 0.40. For both the equally weighted and GDP-weighted emerging market index, the correlation was 0.56. The correlations between emerging markets and the U.S. index are even lower than those reported relative to the MSCI World. For 16 of the 20 individual markets, we found the correlation with the U.S. market to be lower than that with the MSCI World, which indicates that for U.S. investors, emerging markets offer particularly attractive diversification opportunities. The mean U.S. dollar excess return (return minus the risk-free rate) in 18 of 20 emerging markets was found to be higher than that available from the U.S. or MSCI World indices. It was negative in only one market, Portugal. The developed market indices of the United States, EAFEC, and MSCI World provided an average excess

return of about 50 basis points per month, but both the GDP-weighted and equally weighted emerging market indices provided excess returns approximately twice as large. The performance in Latin America is remarkablean annual excess return of more than 22%. From a U.S. investors perspective, Latin American equities represent a far superior portfolio addition than an EAFEC or broad emerging market investment. The Latin American markets provide a return premium that is nearly 10 times the premium offered by the EAFEC and more than twice that offered by the GDP-weighted emerging market index. Interestingly, in U.S. dollar terms, only 10 of the 20 individual emerging market Sharpe ratios were found to be both positive and significantly different from zero. The Sharpe ratio for Portugal is negative and significant. In 11 of the 20 countries, the Sharpe ratio is less than that for the MSCI World. The Sharpe ratios for all the aggregate emerging market indices, however, are positive, significant, and greater than those reported for the developed market indices. Previous research indicates that emerging market returns are often non-normally distributed. Therefore, looking at the Sharpe ratio alone does not tell the complete story regarding the attractiveness of emerging markets. We found a positive skew in 17 of the 20 emerging markets and excess kurtosis in all the markets, so the JarqueBera test indicated a non-normal distribution of returns in all 20 emerging markets for the period. In these conditions, using the standard deviation penalizes markets with large positive returns. When we used measures that account for asymmetrical distributions, we found that broad emerging market indices have downside risk that is similar to that in developed markets. Furthermore, the Sortino ratio (the difference between the mean portfolio return and the risk-free rate divided by the downside deviation) for the equally weighted emerging market index was more than twice that available from developed market indices. Thus, we conclude that the high risk commonly attributed to emerging markets comes in the form of upside variation, which should be of relatively little concern to investors. We also considered returns and risks to emerging market equities during times of U.S monetary easing and tightening. As a measure, we followed previous

researchers who identified the single measure of change in the direction of the Federal Reserve discount rate to be effective in categorizing U.S. financial market conditions; a further benefit of this measure is that it is available to investors on an ex ante basis. Research has found that an increase in the discount rate initiates a restrictive monetary environment (a period reflecting heightened concern about inflationary pressures) and a rate decrease identifies the start of an expansive environment (a period in which inflationary pressures are relatively subdued). When we applied this approach to our study period and markets, we found that emerging markets are valuable to the developed market investor during periods of heightened inflationary concerns. Latin American markets are particularly impressive as a diversifier during restrictive monetary environments by offering higher Sharpe and Sortino ratios and lower correlations than that available from an EAFEC or an emerging Asian market investment. Based on this evidence, we argue that the superior investment benefits offered by the Latin American index may be attributed to the relatively heavy reliance Latin American companies place on the export of commodities. To evaluate the implications that emerging markets have for portfolio performance, we generated alternative efficient frontiers from the equity indices. In general, we found that emerging markets allow investors to achieve lower risk and vastly expanded riskreturn possibilities than what is available from developed market portfolios. Latin American markets consistently received the largest allocation in these efficient frontiers. Finally, we confirmed that when developed market investors need diversification the most (when U.S. inflationary concerns are elevated) is precisely when the benefits of investing in emerging markets, and especially Latin America, are the greatest.
The full paper is posted on SSRN: How Large Are the Benefits of Emerging Market Equities? C. Mitchell Conover, CFA, CIPM, is associate professor of finance at the Robins School of Business at the University of Richmond. Gerald R. Jensen, CFA, is the Jones, Diedrich, Mennie professor of finance at Northern Illinois University.

Robert R. Johnson, CFA, is a professor of finance at Creighton University and a board member at RS Investment Management.

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