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Sky-high returns make emerging markets worth a calculated risk

By Reynaldo Marquez | August 18 2007 05:35PM

Advisors are doing themselves a disservice if they categorically bar emerging market mutual funds from their clients’ portfolios, say investment experts. Stock market returns in this sector exploded by 217% in four years, compared with 100% and 54% for North American indices. Caution is recommended, though: at most 10% of investors’ equity holdings should be allotted to this segment, advise financial analysts interviewed by The Insurance Journal.

Hardly a week goes by without media fanfare about the returns of emerging market funds, particularly those of Brazil, Russia, India and China, also known as BRIC.

Their returns are elating fundholders, but are also sparking concern. Why? Some investors prefer a safer ride, taking refuge in North American and European funds.

To invest or not to invest in these markets through mutual funds…This question continues to divide the investor and advisor communities.

Emerging market devotees are convinced they made the right choice, with the stellar returns on their investments as proof. The Morgan Stanley Capital Index (MSCI) of emerging markets, that measures the performance of 26 emerging economies, literally exploded in the last four years.

The Emerging Markets MSCI skyrocketed by 217% between June 30, 2003 and June 30, 2007, far outperforming the main North American indices. By comparison, the S&P/TSX rose by 100%, and the S&P 500 advanced by 54% during the same reference period.

Yet opponents of this type of investment stress that the stocks are very risky because a misstep could plunge investors in the red. They point to the Mexican crisis in 1994 and the Asian financial crisis of 1997 that literally decimated some investors’ funds.

Take your chances

Both sides are partly right, say the financial analysts interviewed. Although emerging markets are still highly volatile, investors and advisors should not categorically exclude them from their portfolios, because they would then miss out on instruments that fuel growth and diversification.

Today, emerging markets are risky because of returns that fluctuate between extreme highs and lows. The unstable political and economic environment of these markets is another structural factor that makes these investments more risky than European or North American securities, says Suresh Goyal, management professor at the John Molson School of Business, affiliated with Concordia University in Montreal. "Therefore, probabilities to make important gains and probabilities to make important losses remain very high," he continues.

Parallel lines

The dizzying returns of these markets is somewhat comparable with trends in the property and casualty (P&C) insurance industry, says Michele Gambera, senior economist at the consulting firm Ibbotson Associates, a Morningstar subsidiary, from his Chicago office.

"For example, as long as property and casualty insurers collect premiums from their clients, they remain profitable. But just one catastrophic loss is sufficient for them to pay an important share of their profits in claims," he points out.

The risks are not merely theoretical: many emerging markets investors have taken a beating.

"During the 1997 Asian crisis it wasn’t rare to see some investors lose up to 95% of their money in [emerging markets]. They then lost up to 50% of their investments in the subsequent Asian crisis in early 2000," says Gavin Graham, vice-president and chief investment officer at the Guardian Group of Funds (GGOF). "The losses were not as bad as the first time but they were nonetheless very significant," he adds.

Emerging markets also pose another major risk, very low liquidity, says Paul Vaillancourt, senior vice-president and portfolio manager at Fiduciary Trust, a subsidiary of Franklin Templeton that caters to affluent clients. He also chairs the company’s asset allocation committee.

Whereas in a liquid market investors can quickly buy and sell investments, a market with poor liquidity does not offer this possibility, Mr. Vaillancourt explains Investors may then find it very difficult to sell a stock in freefall.

Advantages

The picture is not totally bleak. Intrepid investors that venture into emerging markets can reap several advantages. The risks, and risks there are, do not mean investors should avoid emerging funds altogether.

First, emerging markets have a demographic advantage over developed economies like those in Canada, the United States and France. Their population is younger and more entrepreneurial. Pension funds, running deficits and shackling large North American companies, are scarce in emerging economies.

The growth of these economies has also stimulated a burgeoning middle class, known for its feverish consumption for several years running. "When income per head hits a certain level in those markets you don’t get a gradual increase. The number of people buying a Big Mac, buying life insurance products and mobile phones rather tends to explode," Mr. Graham of GGOF points out.

Investors can tap into the dividends of services companies that are profiting from the rise in this middle class, including banks, insurance companies and telecommunications firms, Mr. Graham continues.

For example, Hong Kong Bank, the State Bank of India and Korea-based Kookmin Bank have all been boosted by the expanding middle class, Mr. Graham says. "Those companies are just as profitable and just as stable and pay as well as any other big Canadian, American or European companies."

"The risks should not shy away investors from emerging markets. They should all have some of these markets in their portfolio," says Mr. Gambera of Ibbotson Associates.

"Those funds are important and useful to the portfolio because they add diversification to it," he says. "Being well diversified is the cheapest way and more logical way to avoid having big financial losses."

Investors should ease into emerging markets, the analysts say. No more than 10% of the equity portfolio weighting should be invested in this region, says Mr. Goyal of the John Molson School of Business. He adds that he has successfully invested in the past twelve years with no help from financial advisors.

"The ideal amount should be 10% or less. Emerging markets have performed very well in the past years but they are very volatile by nature." Mr. Goyal thinks that beyond this threshold, risks become too high, at least for the average investor. Younger and braver investors could increase the proportion to 15%, he suggests.

Proportional weighting

Other analysts echo his view. Mr. Gambera of Ibbotson Associates, considers a proportion of 10% sensible. Why? "Emerging markets MSCI index represents 10% of the world’s industrialized countries. So it makes sense to have in your portfolio a weight that reflects that distribution," he answers.

At GGOF, this proportion varies between 5% and 10%. Fiduciary Trust opts for a weighting of closer to 5%, Mr. Vaillancourt confirms. "Our standard weighted portfolio looks like this: 36% Canadian bonds, 83% Canadian equity, 13% American equity and 18% international equity. Of this 18%, we invest 5% in emerging markets. For a growth portfolio, this proportion would be 10%," he explains.

Director of the portfolio advisory group at Desjardins Financial Securities, Luc Girard has an important message for the industry. He wants to urge financial advisors not to succumb to the siren song of high returns or to pressure from clients dazzled by the performance of emerging markets funds. He cited the ground rule in investment: respect the client profile. The first thing to consider is the clients’ investor profile. Financial advisors must act in keeping with the profile, particularly when it comes to their client’s risk tolerance," he notes.

"Asset allocation is fundamental. It explains 93% of your returns. Bargain hunting should come last. This applies to purchase of both stocks and mutual funds."

The financial analysts interviewed agree that people should not invest in emerging funds out of greed. Instead, this region should be viewed as a source of asset diversification, they say.

Vincent Delisle, portfolio manager at Scotia Bank, the most international oriented member of the five large Canadian banks, is far from being caught up in the emerging markets craze. "The fact that the media are now taking a very keen interest in emerging funds is a blatant alarm signal. Often, when journalists call to ask us about the performance of a sector, this means we are getting closer to the peak of the curve than the trough. We saw the same phenomenon before the burst of the tech bubble, in the early 2000s," he says.

Mr. Delisle explains that there are more prudent ways to profit from emerging market returns than investing part of one’s portfolio directly. What are they? Simply continue to contribute to a Canadian equity mutual fund, he replies.

Canada and the world

"Since 2000-2001, the Canadian stock market has been strongly correlated with the performance of emerging countries, which import huge quantities of raw materials from Canada. The performance of the S&P/TSX is strongly linked to the dynamism of emerging countries," Mr. Delisle explains.

"This means investors can profit from the wave of Chinese and Indian growth, because nearly 50% of our index is sensitive to the prices of raw materials," he continues.

In fact, 46% of the Canadian S&P/TSX index consists of Canadian producers of natural resources, including petroleum, energy and forestry products. Financial institutions make up another 30% of the index.

He adds that the growth of these emerging markets cannot continue at the same pace indefinitely.

Mr. Gambera, of Ibbotson Associates, insists that emerging funds help increase portfolio diversification. But advisors have to be able to pinpoint the most promising emerging market. Not all emerging funds are good diversification tools, he warns.

Because the Canadian index is strongly correlated with the performance of emerging markets, which consume considerable natural resources, Canadian investors should focus on emerging markets that are large producers of industrialized goods.

Concentration alert

"If an investor’s portfolio is already heavily invested in Canadian natural resources then one should avoid putting more money into that asset class," Mr. Gambera explains.

"That means that no money should be invested in countries such as Chile or Venezuela. Just like Canada, those countries are important producers of commodities like copper and oil. There will be no diversification. On the other hand, part of a client’s portfolio should instead be invested in funds from China or India so that investors profit from the growth of those countries. These countries, unlike Canada, do not produce commodities but are important producers of industrialized goods."

Mr. Graham of GGOF concurs. "Because Canada is an important producer of commodities, advisors would not want to invest their clients’ money in other commodity producing countries. That would be getting much of the same. They should turn to Asia rather than Latin America."

All the same, the two analysts share a relatively similar outlook on the growth of these markets. "It is important to think about these markets from a long term perspective," Mr. Gambera says. "Just because they have very well performed in the past three years, it does not mean they will continue to grow at the same rate for the next five years."

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