Wednesday, May 19, 2010

Emerging Markets: It is Different This Time. Last 15 years show clear pattern according to LMG Research


After a set of detailed, thematic contributions this time one that is more 'top-down' and abstract. More in a style that we normally experience when going through academic investment books. The LMG Emerge Global Tactical Asset Allocation (GTAA) System incorporated 50 countries when we created it 7 years ago, in cooperation with Noble Prize Laureate Dr Harry Markowitz. During the last 3 years we have doubled the country set. Reason: Emerging and Frontier Markets are getting more important. Maybe some of them not so much for Western investors (yet?), but definitely so for investors from bigger developing countries. Compare for instance the activities of the Chinese and Middle Eastern wealth funds and other investors in Africa. 

But even in the West interest in the smaller countries is growing. With a shift from 'development aid' to 'economic assistance', Western governments, institutional investors, charities and development aid agencies have shifted focus. In the new approach - which is part of the so-called ESG (environmental, socially-responsible and good governance) approach to investing - donors do not simply look to needs or other non-investment factors alone, but incorporate economic factors in their decision taking process. Knowing that we do not have enough money to stimulate economic growth in all poor countries of the world, we do have to make choices. And there is nothing wrong with the incorporation of economic factors in that decision taking process.

In this report we look at the last 15 years of data in our databases and analyze return and risk in financial markets. We give separate attention to Developed Markets Equities, Emerging Markets Equities, Global Bond Markets and Gold. Our averages are market-value-weighted. During the period under study the relative weight of Emerging Markets went up. At the moment these nations have a combined market value of some 10-15 percent of global financial wealth in equities. When looking at international debt through bond titles it is far less. That is why we refrained from separate analysis of Emerging Bond Markets in this small study. Emerging Market bonds (foreign currency denominated borrowing) is incorporated in our Global Bond Markets index. We incorporated Gold as a commodity, because we always hear about Gold being a great diversifier and hedge whenever markets are in a turmoil. The last few years were great years for 'gold diggers'. Was Gold really that good an asset class? 

The reason why we present you this little study for this 15 year period is threefold:
  1. Graph 1 shows that Emerging Markets were the best performing index, with Gold a good second. How did that happen? And Bonds were the least performing notwithstanding some people making us believe they are the best and 'that one should forget about equities'.
  2. Academic scholars do normally analyze financial market data in 3 or 5 year intervals so as to tell us something about stability of return and risk indicators. With our 15-year window we can create 5 periods of 3 or 3 periods 5 year. A nice set of windows to tell us more about stability.
  3. A longer window might have been nice for developed nations, but the group of Emerging Markets that we have reliable data for and/or that had equity or international bond markets to start with becomes rapidly smaller. We wanted to test and compare using a broad Emerging Markets index.

Graph 1; Long-term, 1994-2010 annualized returns and risks
Selected Asset Categories
Source: LMG Emerge Database
It was a remarkable fifteen year period. In terms of returns Emerging Markets outperformed Developed Markets by 1.2% per annum. And just as remarkable: Gold outperformed Developed Markets as well. Bonds didn't do bad: of course, they were nr 4 in terms of annualized returns, but please do also note that the risk associated with bonds as far less than that of the other asset categories.

Risk is measured here as the volatility, i.e. the standard deviation of returns. How to interpret that? The standard deviation gives an indication about the actual return interval of an asset class. Take for instance Gold: an annualized return of 7.54 percent and a standard deviation of 15.42 percent translate into the following interpretation. Two thirds of actual outcomes lie in an interval ranging from 7.54 - 15.42 = -7.88 percent to 7.54 + 15.42 = 22.97 percent. The other one third lies outside this interval. I.e. quite some uncertainty, with very good years with returns in excess of 23 percent still possible in approximately 15 percent of cases, but negative returns of less than 8 percent are just as likely.
Another risk factor that we could look at is 'beta', or market risk. 'Beta' measures the sensitivity of asset class returns to movements in the underlying market index. The higher beta, the more sensitive the asset class for changes in the underlying index. We will pay more attention to 'beta' in the chapter entitled BETA below.


There ain't no such thing as a free lunch in financial markets. Academia has taught us this in a convincing manner. But this is not the same as saying that it is impossible to beat the benchmark. Research has shown that it is possible for 'best-of-breed' investors to beat their market. However, unfortunately too often market followers tend to believe that there are far more guru's or good managers out there than there actually are. This is especially important in Emerging Markets. The more volatile the markets, the bigger the risk. But: also the bigger the difference between good and bad asset managers or investors. The fact that information quality and quantity is also less in Emerging Markets than in Developed ones does add to that. As a result, the difference between top-level specialists in Emerging Markets and the mediocre colleagues is larger than what we witness in other asset categories.

This translates into a very interesting finding in the underlying sample. First, the risk premium - that is the difference in return between risk-free investments on the one hand and the returns on a risky asset class on the other - is relatively low. Scholars like Wharton professor Jerry Siegel did long-term research using many decades of data and came to the conclusion that a 'normal' risk premium would be 2-3 percent. In the period under study Equities in Developed Markets outperformed Global Bonds by less than a percent. Knowing that Global Bonds outperformed the short-term risk-free rate (money market) by about 0.5-1.0 percent, this translates into a relatively low risk premium. Knowing that historically returns on equities have been higher, we can conclude that it was relatively speaking a mediocre (at best) period for developed stock markets.

Emerging Markets did a better job, albeit that their excess volatility implies that they should be incorporated in a well-diversified portfolio. But, with a good risk premium and a bigger likelihood for informed investors to beat the asset class index, the actual result could even be nicer for those taking Emerging Markets serious.

Gold did surprisingly well. We believe that this is normal in a transition period. In this transition period Emerging Markets have been upgraded to a 'real alternative' for Developed Markets investing. And this will be even more the case when investors in the biggest financial market place of the world, the USA, start to realize that they are terribly underweighted when it comes to international investments in general and Emerging Markets investments in particular. Good initiatives like the website Emerginvest can help bridging this gap. If so, it will create an additional money flow into Emerging Markets during the next 15 years. A period during which the relatively weight of these countries in the World Index will continue to grow. In terms of GDP weights Emerging Markets are already about 35-40 percent of the world, i.e. market-value-weights are still terribly lagging. And that pattern will change in such a way, that market value weights will converse in upward directions for Emerging Markets and in downward direction for Western Markets. And that longer-term trend has nothing to do with Greece, Ireland, Portugal, Spain or other problems in smaller European countries or with US Health Care reform. Western countries are mature, grow less and therefore will gradually but slowly give up some of their relative share in the global indices. Quite as simple as that. 

During the transition period 1994-2010 Gold was a more than reasonable alternative, because it was a great asset class for those that did not know what to do and when to do it. A kind of safe haven. We believe that this will continue for some time to come, albeit that - when Emerging Markets become even more main stream - the relative need for this type of safe haven will gradually vanish. In that process Emerging Market Bonds will definitely become a new mainstream asset class. In other words: fifteen year down the road - when we repeat this exercise - we will definitely have to pay separate attention to them instead of hiding them in the category Global Bonds.


1994(12) - 1997
Graph 2 repeats the exercise of graph 1 for the period 1994 - 1997. Emerging Markets Equities and Gold were non-performing assets with negative annualized returns and relatively high risks, albeit that the risk associated with Gold was smaller than its long-term average. But obviously that didn't really help investors since it was associated with an annualized - 8.75 percent return. This was the best period for Developed Markets Equities with a 17.11 percent annualized return and a historically low volatility. Emerging Markets were still struggling with lousy monetary policies, weak currencies and political instability.

Graph 2; Annualized Returns and Risks 1994(12) - 1997
Selected Asset Classes; The best period for Developed Markets Equities

1998 - 2000

Graph 3 presents the data for the period 1998 - 2000. This was again a period during which Emerging Markets were struggling. Not a good asset category yet. The Chinese were growing, but BRIC nations (Brazil, Russia, India and China) were not a catalyst for the World's globalization process. On the contrary, uncertainty about financial management and political situations in Emerging Markets still prevailed. Combine that with the - still existing - governance issues and it is clear: who would like to take a risk in these markets, when knowing that there was a more than reasonable alternative available? And that alternative was still 'Developed Markets Equities' with an annualized return of 12.07 percent. Interest rates didn't drop further as a result of which bond returns stabilized at what is considered an average level of approximately 5 percent.

Graph 3: Annualized Returns and Risks (1998-2000)
The old world order: Western Equities and Bonds still topping the tables

2001 - 2003

Gold was the best performing asset class during this crisis period. Nothing new there, since that was according to all stock market specialists the standard role of that asset class. Good performance when markets are in disarray and mediocre / poor performance otherwise. What was remarkable though was the good performance of Emerging Markets equities. Normally - with their relatively high beta's / market risk (see also the chapter BETA below) - they would catch a severe cold when Western markets sneeze, but this time the crisis in Western markets due to a combination of political and economic problems on the one hand, a struggling introduction of Euro, international tension due to Iraq and the aftermath of the Millennium bug crisis (that had lead investors into nervousness but in the end didn't really mean that much) seemed to be a Developed Markets-only problem. Graph 4 presents the data:

Graph 4; Annualized Returns and Risks (2001-2003)
Selected Asset Categories
Western Markets stressing....
But what is 'wrong' (too good performance!) with Emerging Markets?

2004 - 2006
During the period 2004-06 everything seemed to turn back to 'normal' at first glance. Graph 5 shows that Developed Markets Equities were once again back on their normal track. Well, actually they were doing slightly better than normal which was to some extent indicative of a correction in which the poor performance during 2001-03 was at least somewhat brushed off.

But there were a few strange things going on. First, Emerging Markets and Gold were doing good too. Wasn't Gold supposed to be a defensive asset class? I.e. do well when regular asset classes are struggling? Second, the volatility of Developed Markets Equities was extremely low by historical standards. As if Western investors saw no danger but where at the same time buying everything, including Gold and Emerging Markets Equities. It was a period of strong optimism and enormous activities by Hedge Funds. But at the same time it was also a period during which - when looking at the underlying global economy - the Western world was transferring continuously growing sums of money to Emerging Markets due to its hunger for Energy resources and cheap Chinese products.

Markets were still assuming that this balance of payments deficit was no problem. Didn't we see that before? Didn't the US always have that kind of deficit with Europeans having the surplus but not the financial market infrastructure? Money would then automatically flow back into the system via Wall Street. But it was different this time. Sure, the Chinese and others in Emerging Markets were buying US Bonds but they weren't big buyers of Western stocks. What was happening was that institutional and private investors in the Western world translated optimism about the structural long-term growth story in Emerging Markets into acquisition of stocks both there and here!

Graph 5 is therefore an odd one, one where almost all asset classes are performing well and that was indeed too good to be true!
Graph 5; Annualized Returns and Risks (2004-2006)
Selected Asset Categories: It seems too good to be true! 

2007 - 2010(4)

And it was too good to be true. The Global Crisis is still fresh in our memory. With our 'traditional' way of thinking this should be a period during which Gold and Global Bonds would do reasonably well and Equities bad. But see what happened, Equities in Emerging Markets were incredibly volatile but they weren't destroyed. Their previous fate was always that collapse during crises was not to be completely compensated for in good years. But this time round they ended up in the plus - albeit at a poor, bond-like level (but with large equity risk) - whereas Developed Markets Equities scored their second negative period in 10 years time.

Graph 6 presents the overview for the most recent sub-period (Note author: we added the most recent four months in this sub-period so as to be up-to-date. Obviously that period was the beginning of a new sub-period 2010-2012. In an update of this article in a couple of years we will of course reclassify the Jan-Apr 2010 period).

 Graph 6; Return and Risk (2007-2010(4))
Selected Asset Categories: Gold as medicine in bad times...
But aren't Emerging Markets doing too good?
LMG: No, it is different this time 


In our presentation above we looked at standard deviation, or volatility, as our risk measure. But when incorporating investments in a diversified portfolio it is at least as important to look at market risk or 'beta'.  

In Graph 7 we present the results: we used the Developed Markets Equities as pivot asset class or 'market definition'. The graph clearly shows that Emerging Markets equities are - as a group - more sensitive to international equity market movements. Their 'beta' can vary between 1.0 and 2.0. This is good news when you expect Global Equity Markets to do well, but it does also imply that they will do less good when markets perform poorly.

Graph 7; Market Betas
Gold and Emerging Markets Equities
Great Asset Classes over 1997-2010...
But also less stable when it comes to their risk level

Notwithstanding the fact that we believe that Global Bonds as an asset class will do less good than they did historically due to demographics changes and the growing interest in Emerging Markets Bonds, we cannot do without them due to their stable and extremely low beta. They provide good diversification during periods when equity markets struggle.

Gold is an interesting asset class. When looking at its return track record above, its average performance was almost as good as that of Emerging Markets Equities. However, its volatility and beta are much lower. This implies that we should not underestimate its value in a diversified portfolio. However, LMG Emerge does not believe that historical returns are a reasonably proxy for future returns. You cannot simply translate old track records because the story changes.

The more mainstream Emerging Markets will become, the less investors will panic and withdraw money from the structural growth stories they present. In other words: the flow out of equities into Gold will be less spectacular in the decade ahead of us. On the other hand, demand for gold from consumers in successful Emerging Markets (growing wealth of their middle classes) will provide some compensation, albeit that the financial market for gold is far bigger already than the physical consumer market. But we do believe that it will compensate. 
But don't overestimate that effect. History is full of stories where 'exuberance' about a specific asset class after a prolonged period of good returns and/or low risk translates into over buying. And we believe that a time in which Gold ATM's are being presented to people is one where the risk of overbuying is substantial (see picture above).


 During the last 15 years Emerging Markets Equities and Gold were the best asset classes. In today's economy a lot of people that seem to focus more on the 'old world' believe that the 'end of times' for equities as an asset class is near. This is a huge exaggeration. Bonds were still the weakest in terms of return performance and it should be that way. Bond investors bear less risk and do therefore deserve a lower return. However, the relative return/risk ratio of Developed Markets equities is declining. And that is to quite some extent logical, because the balance of power in the world is shifting towards Emerging Markets. Maybe not yet politically, but definitely economically. Due to this discrepancy between economic and political power we do remain careful and plea for a mixed, well-diversified portfolio but it is a fact that most Western investors carry far too little Emerging Markets holdings in their portfolios. 

Gold was an incredible success story during the last 10 years. But we are quite convinced that this was a direct result of Western investors not really understanding the transition in the Global Economy. When you transfer huge amounts of money (and wealth) into Emerging Markets via the acquisition of Chinese products and Energy, you cannot simply assume that an old equilibrium between Europe and the USA is still the center of the world. Old imbalances are therefore more visible now. We believe that Western investors and governments are smart enough to understand that. Emerging Markets are here to stay, for sure, but a more selective approach is necessary for success in the period 2010-2025.

The performance of our own asset allocation system has indicated that it is possible to do well in the changing world economy if you incorporate all factors in your analysis without closing your eyes for dynamic changes in the world we live in.

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