Académique Documents
Professionnel Documents
Culture Documents
Outline
I. II. III. IV. V. VI. VII. VIII. IX. Development of Emerging Stock Markets Stock Valuation Methods and Stock Selection Emerging Stock Market Indexes Emerging Stock Market Performance Investment Vehicles in Emerging Stock Markets Differentiating Features of Stock Exchanges Structure of Stock Markets Enabling Environment for Emerging Stock Markets Equity Portfolio Strategies and Building an Emerging Market Portfolio
I.
Emerging Stock Markets have developed rapidly during the last decade, with stock market capitalization growing from US$500 billion in 1988 to $20,950 billion by 2007, but they collapse by almost 60% to $8, 558 billion during the 2008 crisis (source: IMF). During 2009, it recovered to around $14,900 billion: (in $ billion) Asia Latin America Emerging Europe Middle East/Africa Total 2007 13,782 2,292 2,418 2,458 20,950 2008 5,327 1,456 641 1,134 8,558
The Largests markets are in East Asia, including China and India. In Latin America, the markets in Brazil, Mexico and Chile grew rapidly. In Emerging Europe, Russia grew fast. In Africa, stock markets developed in SA, Egypt, and Morocco.
Five EM countries account for almost 65% of the stock market capitalization of all EMs: China, Russia, India, Brazil and Mexico.
However, EMs are still small in size compared with developed countries : the market capitalization of EMs of $9.9 trillion is only 20% of the world equity capitalization of $47 trillion in 2009. Nevertheless, the stock market capitalization of countries such as China, Russia, and India are in excess of US$800 billion and are comparable in size to those of many developed countries. Key Statistics for selected EM regions are given in the following tables.
Source: IMF, Financial Stability Report, October 2010 6. Data for Emerging Economies is based on a narrower new definition of EMs of the IMF.
Developing Asia 35 Latin America 5 Central/East Europe 2 CIS 8 Mid East/North Afric 2 Sub-Saharan Africa 3
Total 53
57 15 3 18 2 1
99
81 47 5 36 6 4
184
22 12 1 4 4 9
45
63 20 4 1 2 1
91
Country
S&P Equity Issuance #Listed Price/Earnings (PE) Ratios Rating Abroad ($bn,09) Compies 00 '03 '05 06 07 08 '09 '10Nov
A+ BBB BBBBBBB
AAABBB+ BBBBB BB ABBB BBBBB BBB+
23 12
17 14 45 24 13 19 20 8 na 10 na na 13 na 26
21 15
11 12 9 12 11 9 12 10 na 12 12 na 8 na 22
18 14
10 9 13 11 10 17 11 12 16 17 19 16 14 15 19
19 15
12 11 20 17 7 19 16 18 13 17 14 12 15 16 18
19 14
17 16 27 15 14 26 14 21 15 22 15 11 15 17 22
13 12 27 7 4
10 10 7 10 12 9 7 4 3 5
19 23 37 17 8
21 20 19 22 19 16 19 16 16 13
22 16 43 11 6
14 15 15 24 21 21 20 9 13 13 18 16 16
11 17 9 21 10 22
P0 = D1/(1 + ke) + [D2/(1 + Ke) + P2/(1 + Ke)]/(1 + ke) P0 = D1/(1+ke) + D2/(1+ke)2 +P2/(1+ke)2
Therefore, the 1 period model can be generalized to "n" periods as: P0 = D1/(1+ke)1 + D2/(1+ke)2 ++ Dn/(1+ke)n + Pn/(1+ke)n If Pn is far in the future, it will not affect P0 and can be ignored Therefore, the model can be rewritten as: P0 = S Dt /(1 + ke)t for t = 1 to n If dividends do not change, then, this becomes: P0 = D / ke If D = $20 and ke = t=1 15%, the stock price should be 20/0.15 = $133 The model says that the price of a stock is determined only by its future free cash flow payments (dividends). It does not say that stock price appreciation is not important; but that stock appreciation is derived from future dividends. If a stock does not currently pay dividends, it is assumed that it will pay someday after the rapid growth phase of its life cycle is over. In the meantime, the value will come from stock appreciation. Note that we discount free cash flows to the investor (the dividend payments) and not earnings, since a portion is reinvested.
Since a portion of earnings is reinvested, a firm would increase its dividends at a constant rate g, then: P0 =
Where: D1 D1(1+g) D1(1+g)2 D1(1+g) --------- + ---------- + ----------- +.+ ------------(1+ke)1 (1+ke)2 (1+ke)3 (1+ke)
D1 = Dividend in period 1 = D0 (1+g) g = expected growth rate in dividends ke = required return on equity investments Then, multiplying both sides by (1+ke)/(1+g), and subtracting the initial equation, the model can be simplified algebraically to: D1 P0 = ---------(ke - g) This model assumes that Dividends continue to grow at a constant rate g for ever and the growth rate is less than the required return on equity. If this were not so, the price would be implausibly large.
Calculating dividends from sales, earnings and cash flows In order to estimate future dividends and growth rates: Financial statements must be analyzed and adjusted to reflect international accounting standards. This can be a major task. Future estimates of Revenues normally require a good market/marketing analysis and analysis of competitors. Since dividends are paid from Net Profits after taxes, all costs are deducted, such as interests, depreciation, amortization and taxes. Normally, profits for the first two years are calculated in detail. For years two to five, a company-specify growth rate of expected cash flows is estimated. After year five, it is assumed that the rate of growth of the companys cash flows will revert to the average for similar firms in the market. The weighted average cost of capital is estimated using local information about the risk-free rate and risk premiums, based on the Capital Assets Pricing Model (to be discussed later on).
Example: To find the current "intrinsic value" of a firms stock whose dividends grow at a constant rate of g =5%, paid dividends last year of D0 = $20.00, and the cost pf capital ke = 15%. P0 = D1 /(ke g) But : D1 = D0 (1+g) P0 = D0(1 + g)/(ke g) P0 = ($20.00)(1.05)/(0.15 - 0.05) = $190 The growth rate of 5% pa changes the stock value from $133 to $190 If the stock is selling for less than $190, you would purchase it, since its intrinsic value is higher at $190: the stock price is undervalued. Theoretically, the best method of stock valuation is the dividend valuation approach. But, if a firm is not paying dividends or has an erratic growth rate, the approach will not work well. Consequently, other methods are used.
The PE ratio (price-earning ratio) of a stock is a measure of the price paid for a stock share relative to the annual net earnings of the firm per share (e.g., how many dollars is the market willing to pay for the stock per dollar of income earned). A higher PE ratio means that investors are paying more per unit of earnings compared to the one with lower PE ratio. A high PE has two interpretations: A higher than average PE may mean that the market expects earnings to rise in the future (the growth rate g is significant).. A high PE may also indicate that the market thinks the firms earnings are very low risk and is therefore willing to pay a premium for them.
The PE ratio can be used to estimate the value of a firms stock. Similar firms in the same industry are expected to have similar PE ratios in the long run: (P/E) = (P/E)i The value of a firms stock can be found by multiplying a representative average industry PE ratio times earnings per share: P = (P/E)i x E The average industry PE ratio can be obtained from market data, if the firm is publicly traded, or from past private transactions. It is also useful to determine how the current PE ratio compares with past PE ratios for the same company Depending on the earnings used, there are various PE ratios: "Trailing PE" or "PE ttm": Earnings per share is the net income of the company for the most recent 12 month period, divided by number of shares outstanding. "Forward PE", "PEf", or "estimated PE": Instead of past net income, it uses estimated net earnings over the next 12 months.
Example: What is the current value of Applebees shares if earnings per share are projected to be $1.30? We find out that the average industry PE ratio for restaurants similar to Applebees is 20. P0 = (P/E)i x E P0 = 20 x $1.30 = $26. Advantages of PE valuation: Useful for valuing privately-held firms without share market prices and firms that do not pay dividends. Disadvantages: By using an industry average PE ratio, firm-specific factors that might contribute to a long-term PE ratio above or below the average are ignored. The average PE ratio for EMs in 2005-2010 was 15.2 PE ratios for firms vary across time, countries and sectors, as shown in the following slides.
012
1317 For many firms a P/E ratio in this range may be considered fair value.
Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published. The stock may also be a 1825 growth stock with earnings expected to increase substantially in future.
25+
A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble.
Emerging Markets
Asia
15.0
14.2
15.7
15.8
17.1
19.0
8.5
9.4
20.6
24.3
14.6
15.8
Europe/MEast/Afr
Latin America
17.3 15.7
14.5 14.7
14.6
16.0
6.7
9.0
16.2
18.3
11.7
14.4
As of January 2010
The total equity value of an enterprise can be obtained by multiplying the Price per share obtained from a PE ratio analysis times the number of shares outstanding. A second approach to get equity value is to obtain first the Enterprise Value (EV) and then subtract the value of net financial debts. The EV can be obtained by multiplying the company's Earnings Before Interest, Taxes, Deprec & Amortiz. (EBITDA) times an industry-wide ratio EV/EBITDA which is available from various sources. EV/EBITDA = Enterprise Value . Earnings before interest, taxes, deprec & amortiz. This ratio facilitates comparisons of fundamental profitability among firms, as it eliminates the effects of financing and accounting decisions. In fact, this ratio is more suitable for international comparisons as it is not impacted by the firmss financial structure nor by its policies regarding depreciation and provisioning. It is also the closest readily available proxy for operating cash flow. Large organizations compile these ratios based on their past purchases A number of sources provide EV/EBITDA ratios for various countries.
Depending on sectors and countries, EV/EBITDA ratios range from 4x for low growth high risk firms to 7x for high growth firms with low risk The Argos Mid-Market index of EV/EBITDA multiples measure the evolution of Euro-zone private mid-market company prices. The preparation of the index is based on samples of 942 transactions, which met the following criteria: acquisition of a majority stake, equity value in range 15-150m), certain activities excluded (financial, real estate, high-tech). By November 2010, the average of the indexes recovered from 6.0x to 6.5x
In 2010 in the US, transaction multiples shrank to an average 9.2x EV / EBITDA compared to 10.7x in 2007. This reduction reflects a larger share of distressed transactions, tight financing, and poor corporate earnings. In 2010, a slightly improving economic outlook appears to be supporting a re-awakening of M&A activity for some sectors.
(10) Value of Real Options: Value of alternative sources of revenues or savings that the investment can generate, due to irreversibility (sunk costs) and uncertainty (future cash flows), such as: (i) Waiting (learning) option value (building now or just wait for better knowledge and potential higher returns (ii) Additional investment option value (if invest now in project A, later can invest in B with overall higher returns.) (iii) Abandoning option. How much you lose if the company fails.
------------------------------------------------------------------------------Based on the above equity valuation methods, we have computed the stocks intrinsic value. Then the decision is whether to buy it or not, depending on whether this intrinsic value is above the current market (selling) price. An alternative formulation is to ask whether the stocks intrinsic internal rate of return (the yield that equals cash inflows and outflows) is above or below the required rate of return derived from the opportunity cost of equity capital. The CAPM provides for the calculation of this required rate of return for equities.
By holding over 20-30 different stocks, one can reduce the standard deviation and eliminate the Company Specific risk component. Only the residual Systematic Risk would remain -- and for which the investors would demand a premium. This systematic risk (called beta - ) depends on uncertainties & threats within the economy/sector as a whole and varies by country. Therefore, the required risk premium for an individual stock will depends only on its systematic risk i since other risks can be eliminated by diversification. The risk premium due to this systematic risk will depend on the degree to which the returns on the individual stock is affected by movements in the return of the overall sector/economy.
If the stock return behaves exactly as the market as a whole, the risk premium should be equal to the difference between market returns (Rm) and the risk-free return (Rf): risk premium = Rm Rf Therefore, its return is: E(Ri) = Rf + (Rm Rf ) or: E(Ri) = Rm The expected (required) return equals the market return. But if the stock has greater variance than the market, the risk premium would be higher than the market risk premium by a factor greater than 1.0 Similarly, if the stock has lower variability than the market, the risk premium would be lower by a factor lower than 1.0 The expected or required return for this stock [E(Ri)] is then: E(Ri) = Rf +i (Rm Rf) [the Capital Asset Pricing Model]
The factor i (beta) represents the extend to which the stock i return varies more than the market (i > 1) or less than the market (i < 1). Risk is now defined as the exposure level of the security to fluctuations in the market portfolio, not by its standard deviation.
The value of i for a stock can be obtained statistically as the slope of a regression of the stocks returns to the excess return of a market portfolio (ie, S&P500): E(Ri) = Rf +i (Rm Rf) Its value can be derived mathematically as follows: In equilibrium every stock i must have the same marginal value k: E(Ri) a im = k The marginal value k is its return minus a risk factor related to its market sensitivity risk im . E(Rf) a fm = k Since fm = 0, then k = E(Rf) = Rf E(Rm) a 2m = Rf a = [E(Rm) Rf ] / 2m E(Ri) = k + a im E(Ri) = Rf + {[E(Rm) Rf ] / 2 m }im E(Ri) = Rf + {im /2 m }[E(Rm) Rf ] Thus: i = im /2 m Beta is the ratio of the Cov(Ri, Rm) to the Var(Rm)
An equity investment would be desirable only if its calculated returns (based for example on discounted cash flows) would exceed this expected or demanded rate of return E(Ri) as calculated by the CAPM for the risk.
The E(Ri) therefore represents the opportunity cost of capital (the second best alternative return for an equity investment). It is therefore, the cost of capital for the equity i, as it is the minimum return that should be sought for an equity investment, given its market/country risks. In Ukraine, given Ukraines market risks, the cost of equity capital or required rate of return E(Ri) is estimated at 20% t0 25% in real terms for a normal Ukrainian market risk. For the S&P500 the market E(Rm) has been 8% in real terms.
Example:
Suppose your company is considering an equity investment in a small capitalization firm with a new drug process. The process is inherently risky, i.e. the standard deviation of the project is 75% per year. But the beta for drugs and therefore for this project is only 0.8. The risk free rate (Rf) is 3% and the market return E(Rm) is 12%. The discounting of Cash Flow of inflows and outflows show that the intrinsic internal rate of return of this drug company is 12% (that is, the yield that equals cash ins with outs). Would you recommend this investment? What is the required rate of return on the project? Theory tells us that the answer does not depend upon the volatility associated with the returns. Instead, we use the beta of the project. E(Rdrug) = 3% + (0.8)(12% - 3%) = 10.2% The drugs investment is indeed desirable, despite its high standard deviation, provided that it is part of a well-diversified portfolio.
The investment or portfolio with the highest Sharpe ratio should be preferred, as it gives more return for the same overall risk. As a guide, the long-term return of the S&P500 is 10%, the risk-free rate is 3%, and the S&P500 standard deviation is 16%. Therefore, the average L-T Sharpe for the US market is 0.43. Now it is about 35%. Treynor developed a similar ratio for a well-diversified portfolio, using i instead of i which is: T = E(Ri) Rf i These ratio is used to assess the performance of portfolio managers.
1. S&P/IFC Indexes
Since 1984, the International Finance Corporation (IFC) of the World Bank published, on a daily basis, several indexes for EMs. In April 2000, this business was purchased by S&P. They include:
S&P/IFC Global (S&P/IFCG). It covers 32 emerging countries (2,000 stocks), three regional composite indexes (Latin America, Asia, and Europe & Middle East), and industrial sector indexes. For each country the target aggregate market capitalization is between 60% and 75% of the total capitalization of the stock exchange. S&P/IFC includes only the most actively traded stocks. Corporate cross-holdings & Government ownership of shares (that are not traded) are eliminated. S&P/IFC seeks industry diversification. Each stock enters the index in proportion of its capitalization.
S&P/IFC Investable Index (S&P/IFCI). It measures the market for shares available to foreign investors. It is useful for foreign investors (i) to benchmark their own performance; and (ii) for passive management investments. Adjustments are made to reflect foreign investment restrictions (the weights of China, Taiwan, Korea and India are reduced significantly , and Nigeria is eliminated). Stocks must pass size and liquidity screens. S&P/IFC Frontier Markets. It was introduced in 1996 for 19 countries that were borderline but could eventually meet selection criteria when trade volume and liquidity increases. It is published monthly. The S&P/IFC indexes include financial information, such as: P/E ratios, P/Book Value ratios, and dividend yields.
These studies show that sudden increases in foreign direct investments are early indicators that stock prices will increase. Studies also show that EM equity prices tend to increase faster during the initial period of "emergence" -- (turn around in economic performance), not much before, not later on. Investors who can detect a forthcoming change in policies can enjoy large returns. For the US, studies show that equity prices are positively correlated to expected earnings and negatively correlated to interest rates.
B. Volatility of EM Stocks
Equity prices in EMs have been characterized by wide fluctuations, greater that that of developed markets. For example, South Koreas stock price index evolved as follows: 1986-89: a 400% increase; 1989-91: a 35% drop; 1991-1994: a 70% increase; 1994-1998: a 70% drop; 1998-1999: a 400% increase; 1999-2001: a 50% drop. By April 2003 it was 10% up from mid 2001.
This high volatility in equity prices is the result of: Inconsistent application of economic policies in EMs that leads to periodic financial crises. Thin, narrow markets for most EM securities. The tendency of investors to be driven by the herd due to poor information. EM price volatility does not follow a normal distribution or any symmetric distribution of returns. As a result, the probability of a large negative price movement can be high. Therefore, the standard deviation is not a sufficient measure of market risk. Empirical statistical studies also show that equity price volatility is correlated to inflation rates: countries with high inflation tend to have larger stock price volatility, Inflation, in turn, is caused by the adequacy of fiscal policies (the size of fiscal deficits) and monetary policies (the balance between money supply and demand).
EM equity prices drop drastically during periods of financial crises. The most fundamental causes of a financial crises are inadequate macroeconomic policies, which produce unsustainable external imbalances (high current account deficits and unsustainable foreign debt) and internal imbalances (high fiscal deficits or low private savings). External and internal imbalances lead to internal instability (high inflation) and external instability (currency devaluations). The wide fluctuations in the stock prices of EMs should not dissuade investors, given potential returns and diversification benefits. But investors should resist the temptation to go to hot markets in fashion; instead, they should look at the fundamentals of each market. The lesson from the 1990's crises is that investors in EMs should not just look at the financial statements of companies. A fundamental analysis of the overall economy is required.
How can the better returns of EMs from 2003 to 2007 be explained? They are not explained by increases in valuation: In fact, the P/E ratios of most EMs did not increased excessively and were below those of developed countries. Better returns in EMs were explained by two factors: (1) the better macroeconomic performance in most EMs in this period, as reflected by higher rates of growth and lower inflation; and (2) Greater appetite for EM assets due to high liquidity (investment resources) and lower returns in developed countries. What explains the collapse in 2008? The international crisis in developed countries, and excessive borrowings in EMs during 2007 and 2008.
The stock bubble of the 1990s (dot-com bubble) was due to the speculation that a New Economy -- supported by better technology, computers, e-commerce and other internet applications -- would generate higher productivity growth. For several years, this led to a financing boom (supported by new Venture Capital), higher investments and growth, high P/E ratios and high stock pricesuntil 2000! Then another boom (in housing) was supported by low interest rates and deregulation of banks.until 2008!!.
BEST PERFORMING STOCKMARKETS 2010 Sri Lanka Argentina Estonia Thailand Peru Ukraine Colombia Chile Malaysia Indonesia South Africa Philippines Korea India Turkey Singapore 71% 70 56 50 49 49 41 41 32 31 31 30 25 19 18 18
WORST PERFORMING STOCKMARKETS 2010 Greece Spain Ireland Italy Kazakhstan Slovenia Portugal Lebanon Bulgaria Jordan Hungary Czech Rep France UAE Romania Belgium -46% -25 -19 -17 -17 -16 - 14 -13 -12 -12 -11 -7 -7 -5 -2 -2
BEST PERFORMING EMs STOCKMARKETS (MSCI) 2009 SriLanka 184% Brazil 121% Indonesia 120% Russia 100% India 95% Chile 82%
WORST PERFORMING EMs STOCKMARKETS (MSCI) 2009 Bahrain: -36% Ghana -26% Nigeria -24% Trinidad & Tobago - 13% Kuwait -10% Morocco -8% 2008
2008
Tunisia Morocco Lebanon Israel Qatar Jordan -8% -12% -22% - 30% -30% -35% Ukraine: Bulgaria Russia UAE Pakistan Estonia
V.
Investing abroad has been facilitated by the development of a number of equity investment vehicles. The main ones are the following:
1. Direct Purchases.
The direct way to trade in foreign equity is on the foreign stock market itself. But this route is usually reserved for large institutional investors because of the issues involved: initial foreign exchange purchase, a custodian to hold the shares, a bank account to collect and repatriate dividends, pay commissions, pay taxes, etc. In addition, the investor should be familiar with the issues of delivery, clearing, and settlements, as will be discussed later. All these issues substantially increase the transaction costs of foreign stock markets. Other simpler schemes are given below.
..
Owners of ADRs have the right to redeem their ADRs and obtain the true underlying foreign shares. This possible arbitrage ensures that the price of the ADR and the foreign shares will be very close, though there may be a discount. Investors can trade their ADRs without recourse to the foreign equity market and without relying on foreign clearing and settlement; thus reducing trading costs. In an sponsored ADR, the foreign firm pays a fee to the depositary bank for the program cost. In an unsponsored ADR,the depositary bank takes the initiative to profit from a popular foreign issue. ADRs bear all the foreign exchange and commercial risks of the underlying foreign shares, even though they are quoted in US $. Global Depositary Receipts (GDRs) are similar instruments trading in other countries, particularly in London and Luxembourg. ADRs and GDRs are generally called DRs
Level 1 ADRs are those ADRs that are not traded in an exchange; but they trade in the over-the-counter markets. They do not require full SEC registration. The company is only required to disclose its Financial Statement in English and information provided in its home Annual Report (no need to GAAP accounting principles). Level 2 ADRs are those that meet the disclosure requirements of a US stock exchange and are listed in the exchanges. Level 3 ARDs are those that fully complies with US accounting principles and disclosure requirements, and they may raise equity in the US through a public offering. Rule 144A ADRs are those privately placed with Qualified Institutional Buyers. As a private placement, there is no need of registration and review by the SEC. These ADRs can be resold only to other Qualified Institutional Investors.
In 2008, more that 2,250 sponsored DRs were traded in the US and Europe, from about 76 countries (from 350 DRs from 24 countries in 1990). In 2008, the total value of outstanding DR's reached $1,800 bn ($1,200 bn listed in the US, $320 bn listed in Europe and $250 bn in OTC and others). Demand for DRs have been growing, with trading volume reaching $24 trillion during the first half of 2008, increasing by about 25% pa during the last 10 years. In 2007, foreign companies raised US$55 billion through DR offerings, of which $27 billion was handled by Bank of New York Mellon, $11 billion by Citibank, $10 billion by JP Morgan, and $8 billion by Deutsch Bank. A large number of DRs are from Emerging Market companies, including India (276), Russia (195), China (143), Brazil (129), South Africa (69), Mexico (66), Ukraine (65), Korea (59), Turkey (53), Poland (38), Kazakhstan (24), Hungary (16), etc. Ukrainian companies include metallurgical, auto, retailers, oblaenergos, banks, etc The largest Emerging Markets companies raising funds in 2007-08 were Gazprom, Lukoil (Russia), Petrobras, Vale (Brazil), American Mobil (Mexico), and Suntech (China).
3. EM Mutual Funds.
These are organized as corporations with a board of directors. Investors purchase their shares which are pooled and invested in EM securities. Mutual funds can be Global (US and non-US shares), International (non-US shares), Regional (in a particular area), County (a particular country), or Sector Specialty (such as energy). There are two types: Open-end and close-end mutual funds. An open-end fund stands ready both to issue and to redeem shares, at prices reflecting the net-asset value of the underlying foreign shares (assets minus liabilities). The shares of the open-end fund are not normally traded in secondary markets. A close-end fund issues a fixed number of shares against an initial capital offering. It will not redeem the shares but they are traded in the secondary market at prices reflecting a premium or discount relative to the net-asset value of the underlying foreign shares.
The owner of a share of an open-end fund earns a return based on the change in the net-asset value of the fund. The owner of a share of a close-end fund earns a return based on the net-asset value of the fund plus the change in discount/premium. Studies in 1994/95 showed that, on average, the variance of close-end country fund returns is three times larger than the variance of the underlying foreign securities. The premium/discounts of close-end funds are mean reverting and are affected by news about local events. On the other hand, open-end funds are not practical or costeffective for foreign investment in Emerging Markets. This is because it is hard for an open-end fund to stand ready to liquidate stock positions on demand, since foreign equity emerging markets lack liquidity, impose higher transaction costs and restrict full liquidation/repatriation of positions.
Close-end funds are not forced to liquidate positions when shareholders wish to exit the fund. Exit or purchases will however affect the premium or discount of the fund shares. Close-end country funds have become the fastest segment of the market in the last decade. EMs country funds include funds for Argentina, Brazil, Chile, China, Mexico, Philippines,China, India, Indonesia, Korea, Malaysia, Taiwan, Thailand, Turkey, Russia, Ukraine, etc.
4. Index Funds
Index funds are investment funds whose shares are traded in stock exchanges and are intended to track the performance of a single country index. Therefore, they are useful for investors who wish to follow a passive investment strategy. Index funds started in 1987 when the Toronto Stock Exchange created a fund to hold baskets of the stocks in the Toronto 35 Index. In 1993, the American Stock Exchange began trading shares in an index fund that held a portfolio of all common stocks in the S&P 500 (called Standard and Poor Depository Receipts -"Spiders"). It was an instant success.
In 1996, the American Stock Exchange opened another index fund for international equities, the World Equity Benchmark Shares Foreign Fund). Its shares were called "Webs". They are now called iShares (for index shares). The iShares fund has 20 separate portfolios, each one designed to match the performance of a given country, including EM such as Hong Kong, Mexico, Malaysia, Taiwan, Korea. The iShare portfolios are designed to track the Morgan Stanley Capital International (MSCI) Index for that country. They are managed by Barclays (BGI). The New York Stock Exchange in 1996 introduced its own Index Fund, Country Baskets. CBs were available for 10 countries and are designed to track the Financial Times/S&P Actuaries World Index for that Country. They are managed by Deutsche Morgan Grenfell.
CBs and iShares combine the features of close-end funds, openend funds and ADRs. To initiate the fund activities, they rely on the sale of a creation unit. In exchange for a sum of money (US$2 million for CBs and US$0.5 million for iShares), an investor purchase a creation unit in one index fund. The fund manager uses these funds to buy shares and DRs whose performance will match that of the country index. Each creation unit divides into a specified number of shares that the investor can sell through the corresponding stock exchange. Thus, like an open-end fund, the size of the CBs and iShares can grow without limit; but the shares are traded at any time in the secondary markets, like a close-end fund. As a DR, prices of CBs and iShares are kept close to the netasset value of the underlying foreign shares, through arbitrage.
5. Hedge Funds
A hedge fund is an organization whose management receives compensation in the form of performance incentives, rather than the amount of assets held or transactions made. Normally the managers are also large investors. In the US, they are usually structured as Partnerships. They raise funds as Private Placements: a private offering to a accredited investors (such as financial institutions) and no more than 35 non-accredited investors. The total can not exceed 100 owners. Normally a typical investment is over $250,000. Under a Private Placement, the fund avoids registration under the Investment Company Act of 1940, which imposes limitations on the types of investments made and requires strong disclosure. If the Hedge Fund is organized outside the US -- called offshore fund -- it can avoid the limitations in raising funds. Popular places with low regulations include Bermuda, Cayman Islands, Bahamas, Mauritius, Luxembourg, Switzerland, Dublin.
Originally, in 1949, hedge funds were introduced A.W. Jones and Co. to maintain highly leveraged but relatively diversified and "hedged positions, with a limited net exposure to overall price movements (they developed fast in the 1960s and 1970s): Market Exposure = (Long Exposure - Short Exposure) / capital Today, Hedge funds follows many different strategies: Market neutral, where the market exposure is low or zero trading on convergence spreads between two securities. Event-driven, seeking arbitrage in bankrupt securities. Opportunistic, taking advantage of any opportunities. Most hedge funds use derivatives extensively. Investors normally have short-term horizons, thereby the hedge fund must have liquidity by investing in short term deals Because of risk management failures, hedge funds have suffered from a large share of failures. Also, because of the lack of regulations, they have been more vulnerable to fraud. In 2002, there were 6,000 hedge funds with $600 billion in assets.
Private Equity
Public equity: Initial Public Offering (IPO) With stock market listing
Private equity is illiquid, ownership is concentrated, valuation is difficult, intermediaries tend to me small, finance is accompanied by control and mentoring
Public equity is liquid, ownership is dispersed, valuation is relatively easy, intermediaries are large, finance is often divorced from control and mentoring
Seed
Early Stage
Development Capital
Buy Out
Pre -IPO
Idea / Seed
Sale
High growth.
Exceptional product / Intellectual Property Need weekly & monthly board meetings and close monitoring
Individual / Family
Financial Investors
Adds value Professionalizes May change Management May merge
Investors (Limited Partners) pension funds, insurance funds, banks endowments, companies, individuals
1 year
10 years
2 years
Marketing
Extension
Follow-on fund
Marketing
10
Commitment Period
Divestment Period
Fees
Fund 1
Fund 2
Fund 3
10
20
30
Deal Alert
Investment Committee
Can be all internal or internal & external
Contacts
Final Documents
Closing
THEN
7. Equity-Linked Eurobonds.
Many Emerging Market companies issue Eurobonds with features such as detached stock options (warrants) and convertibility that provide links to equity shares. These features provide an alternative vehicles to invest in equity. In a country which is largely closed to direct equity purchases from abroad, a convertible bond is one of the ways for a foreign investor to enter the equity market. In other countries, such as Indonesia, with difficult equity clearing and settlement procedures, a convertible bond was used to avoid these equity market problems.
8. International Firms.
An indirect way to participate in the economy of Emerging Markets, is to purchase shares of international companies (US or European) that have a large portion of their revenues and profits from their activities in Emerging Markets. For example, a large portion of the revenues of the UK company JKX Oil, Ltd., depends on its oil investments in Russia and Ukraine. Other large international companies with substantive involvement in Emerging Markets include: American Express, Bayer, Coca-Cola, McDonalds, Gillette, Minnesota Mining and Manufacturing, Nestle, Unilever, Procter and Gamble.
(2) Spot versus Forward Markets. In most markets, stocks are traded on a spot or cash basis. But almost nowhere are stocks, once traded, delivered on the same day: a typical spot or cash settlement of the stock is three to five business days (T+3; T+5). Many East Asian exchanges and Rio de Janeiro follow a forward market approach (such as in Paris): Stock deliveries and settlement take place once a month at the end of the month. At the time of the transaction, the price is fixed and a deposit is required. (3) Continuous versus Auction Quotations. Most major markets offer continuous pricing of stocks, at least for the major stocks, with market-makers ensuring liquidity. Market-makers will quote both a bid price (for buying) and a asked or offer price (for selling); and stand ready to trade at these prices.
In smaller markets, the price is determined by daily auctions: orders are accumulated, and at the end of the day, a price that maximizes the volume of transactions is determined (this is the price where there is equilibrium of demand and supply). This single equilibrium price applies to all transactions.
(4) Centralized (Floor Trading) versus Decentralized Systems. Centralized stock trading at the floor of exchanges continues in many exchanges, due to the advantages to close personal interactions, principally for large transactions. But most stock exchanges in Emerging Markets use decentralized computerized systems as the forum for trading, following either (i) price-driven systems; or (ii) order-driven systems. These stock exchange systems have their own regulations regarding requirements for membership, access to the system, trading rules, listing and de-listing of securities, registration as market-makers, professional responsibilities, settling of disputes, arbitrage, etc. Price-driven systems, such as Ukraines, are based on the NASDAQ system for low-liquidity stocks: It is based on a dealer Price Quotation System (Stock Exchange Automated Quotation- SEAQ). In Ukraine, out of 300 dealers, 200 are members, linked to the system.
Members are free to register as market-makers, quoting firm bid/asked prices for active stocks, up to a maximum limit. The difference between the bid and asked prices is the spread which is the source of income for the dealer. A 1994 Harvard study of the US NASDAQ, found that in many stocks, the spread was always $0.25 a share, while in others went as low as $0.12 a share. This prompted to accusations of collusion and a review of competitive practices. Soon thereafter, spreads began to shrink. In this price-driven system, transactions do not happen automatically, but are executed at the order of a member dealer. Once an order arrives to a market-maker, it is obliged to execute it. Both parties are expected to input the transaction and reported it to the main system within 90 seconds. If the receiver of the order does not execute it within a few minutes, the originator can input both entries and report it. Some minor stocks have only a handful of market-makers; big company stocks have as many as 50.
The screen of a dealer would list bid/asked quotations by market-makers for a specific company stock, as follows:
Order-driven systems are based on the Paris and Toronto systems: All exchange members have trading screen in their offices. For listed stocks, members enter their limit-orders, indicating the maximum price for buying the stock (maximum bid price) and their minimum price for sale of the stock (minimum asked). Trading takes place automatically against this computerized limitorder book. When a new order arrives, if possible, it is immediately routed and executed against the limit-order book: it would be possible if the new order has a price for purchase that is above or equal to the minimum price asked by another dealer for the sale of the stock. If it not possible to execute the order, it is entered into the limitorder book for future trading. Since bid/asked orders are not of equal quantities, orders are executed following price/time/size priority rules: (highest bid and lowest asked have priority over other orders).
In some cases, large trades are done over the telephone, rather than left to the computer. Once executed, they are recorded in the computer and taken into account in price calculations. In small stock markets, such as Moldova, trading is not continuous: Members enter their limit-orders between 10:00 am and 2:45 pm. At 2:45 pm entry is closed and orders are matched, as follows: Max Bids (Buyers) Dealer Price # Shares A 4.0 300 B 2.0 500 C 1.0 200 Min Asked (Sellers) Dealer Price # Shares D 3.0 100 E 4.0 100 F 5.0 100
The only transaction that would take place is the purchase by dealer A of 200 shares, 100 from dealer D at $3.0/share and 100 from dealer E at 4.0/share. The average price will be $3.5 per share, which will be registered for the records.
The Lower Level (Level 3) includes the Shareholders. Their share ownership is formally recorded -- for a fee --in specialized entities called Registrars. Registrars will issue Certificates of Ownership, either in paper or dematerialized (electronic) form. There are about 30 specialized Registrars in the US. In many EMs, any agency could be a Registrar, including the same company (until recently, there were 400 Registrars in Ukraine; in Russia, owners disappear before dividend payment date). The independence, qualification and regulation of Registrars is a key factor to avoid abuses and give confidence to a stock market. Level Two includes the Custodians (dealers, brokers, banks) which represent the shareholders, keeping their shares in custody, either physically or electronically (paperless). The Custodians are only entities working with Level One agencies and Level 3 entities. There are 5,000 in the US; 60 in Ukraine.
The Level One agencies include: The Trading Systems: Stock Exchanges and Over-the Counter, where the trading takes place. The Depositary: which receives from Custodians the shares to be sold and keeps them in anticipation of the trade. A centralized, independent depositary is key to give confidence to the market. The Settlement Bank: which keeps the cash accounts of buyers. The Clearance and Settlement System: Trade clearance involves verifying and comparing information provided separately by buyers and sellers and finding out if there is a match. Otherwise, they go back to the dealers. If the match is successful, settlement obligations are calculated. On T+1 to T+3 day, it will check that the sellers shares are indeed deposited in the Depositary and that the buyers do have cash in their accounts in the Settlement Bank.
If so, it instructs the Depositary to transfer the securities from seller to buyer; and gives the order to the Settlement Bank to transfer money from the buyer account to the seller account. Settlement can be made on a gross basis for an individual deal, on a bilateral net basis for more than one trade among two parties, or on an multilateral net basis (the last one is typical in the US). A key function of this system is to protect shareholders rights and provide confidence that payments will be made only if there is delivery of the securities. A Delivery-Versus-Payment (DVP) system has controls to ensure that final delivery of securities (or cash) occurs only if final transfer of funds (or securities) occur. Many EMs have non-DVP systems, with the risk that the full amount of the transaction may be lost.
In Europe, the tradition is to combine the functions of Depositary with Clearance and Settlement Houses. For example, in Switzerland, the securities transfer system SECOM is linked to a separate fund transfer system, SIC. A DVP transaction causes securities to be reserved in SECOM, which then generates a payment instruction from the buyer to the seller in SIC. SECOM releases the securities to the buyer when SIC confirms final payment. In the US, the functions of Clearance and Settlement Houses and Settlement Banks are performed by the National Securities Clearance Corporation (NSCC) and the US Federal Reserves Fedwire Securities and Fund Transfer Systems. In the books of the Federal Reserve, banks maintain both security and fund accounts, which permits simultaneous transactions. In the US, depositaries are organized as limited-purpose trust companies under banking laws.
In assessing the adequacy of the enabling environment for capital markets in the country, the following matters should be analyzed: 1. Adequacy of the Legal and Regulatory Framework for the Stock Market. Does it provide adequate protection of ownership rights for small and other shareholders? Does it contains adequate and severe penalties for fraud? Does it permit sufficient competition to facilitate stock trading and reduce transactions costs? Are the Broker/Dealer regulations adequate in terms of net capital requirements, qualification standards, commission limitations, auditing requirements? Is there a system of self-regulation by market participants?
2. Adequacy of Prudential Supervision of Capital Markets. Is the supervision system capable of detecting abuses, inside trading? What is the role of the national security and exchange commission? Are there conflicts with other agencies? Are the procedures adequate to carry out inspections, off-site and onsite surveillance? How are prudential regulations enforced on market participants? 3. Adequacy of Information, Accounting and Auditing Standards. Are the listing requirements, including documentation of qualitative and quantitative qualifications, satisfactory? excessive? Do the listed companies comply with international accounting and auditing standards?
Are the requirements for disclosure of information satisfactory for Public Offerings? Private Placements? Do they provide for information through Annual Reports with adequate transparency standards, such as compensation of managers? 4. Adequacy of Tax Policies for stock market activities. Do taxes unduly penalizes capital market transactions and profits?
5. Adequacy of the Stock Markets Infrastructure. Does the current market infrastructure protects from counterpart risk: the possibility that the other party (seller or buyer) will not deliver at settlement. Does a central and independent depositary system exist to minimize abuses and risk of non-delivery?
Is there an adequate system for registration and custody of shares? (is an accurate custody of ownership records maintained? will shares be wrongfully lost, challenged? What systems are used to handle the formal Clearing Process? (process of verifying and identifying the traded shares, the identity of buyers and sellers, and the price and date of trade) How good is the system for the settlement of stock transactions (time periods, level of technical fails, adequacy of the delivery-versus-payment system, netting process?) What is the level of technology sophistication and types of risk controls are used in clearance and settlement? What are the sources of trade data and how it is reported? What is the peak and normal processing capacity of the existing infrastructure?
6. Availability of private and sound Credit Rating Agencies. The availability of credit rating agencies has been proven to be a key factor leading to better market discipline and transparency by listed companies. Credit Rating companies exercise a good degree of market control.
Therefore, EM stocks can actually reduce portfolio risks while increasing returns.
The risk of an EM stock is defined by the volatility of its returns.
But contrary to the US situation, the "standard deviation" of returns is not a good measure of risk, since they do not follow a normal or symmetric distribution. To assess the risk of the EM stock, the investor must look at the economic situation of the country.
Another form of international portfolio risk is correlation risk: The risk that a seemingly diversified portfolio will prove to be undiversified in the future because its assets will begin to move uniformly, rather than independently. Increasing cross-border investments and improved communications is increasing the correlation among developed markets. But except during periods of large variations, correlations of developed market stocks with emerging market stocks are still low. These correlations are still low due to the fact that emerging markets are still segmented in an international context. This segmentation is due to market imperfections and constraints, including: lack of information, Government constraints, investors perceptions, etc.
Although, long term gains from diversification are feasible, portfolio managers should be aware that in times of large market movements almost all markets seems to move in the same direction: During periods of disaster there is no safe place to hide. However, the impact of a crisis on other individual EM depends on the economic strength of the country: Countries with sound economic policies have suffered less from crises. All this suggests that rules-of-thumb do not work well in EMs. Investors should carefully build their own Emerging Market Portfolio based on fundamental analysis.
But others would use active management (picking up individual stocks). But since stock selection is less important, they tend to concentrate in large, liquid stocks. In order to forecast the relative performance of the countrys stock exchange, there is a need to look at the soundness of the economy as a whole. A sound economy is one that has both growth and stability. Growth is defined by a high rate of GDP growth. Stability is defined by a low inflation rate (internal stability), and a stable foreign exchange rate (external stability). Sustainable rates of real GDP growth and firm stability are the key factors affecting the performance of the stock exchange. Growth and stability are secured by the implementation of sound economic policies. The following economic policies have been proven to be essential (I for Stability; II and III for sustainable growth).
(I) Macroeconomic Stabilization Policies: Fiscal Policies under which the Government's fiscal budget has a deficit that can be financed by borrowings on a sustainable basis (normally no more than 3% of GDP). Monetary Policies, under which the creation of money (money supply) will not exceed the demand for money (which is affected by income and interest rates). (II) Liberalization of the Economic Environment Liberalization of the Formation and Operation of Enterprises Liberalization of the Closure of Failing Enterprises Liberalization of Product Pricing and Trade Liberalization of the Financial Sector Liberalization of Labor and Land Markets (III) Good Public Governance with Sound Institutions Sound & efficient Government services without corruption Stable and predictable legal environment Low political risks.