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Smithie: Emerging-Markets Indexes Have Let Investors Down

Patricia Oey

Patty Oey: Hi, we're here at the Morningstar ETF Conference. My name is Patty Oey, and I'm a senior analyst covering passive strategies on the manager research team.

I'm here today with Nick Smithie, the chief investment strategist at EG Global Shares. It's a company focused on emerging markets, primarily in ETFs.

Welcome. Thank you for joining us.

Nick Smithie: Thank you, Patty.

Oey: Emerging markets are starting to show signs of life this year after years of underperformance.

Smithie: Right.

Oey: What's changed?

Smithie: I think, Patty, we've had three or four years of stagnant earnings growth in emerging markets, which has really held back performance, both on a relative and an absolute basis. And after the interest rate increases last year and this year in response to the Fed's announcement about tapering, analysts brought down their growth estimates considerably. During the second half of this year, we've finally seen both companies and economies begin to improve beyond analysts' expectations.

So I think we have cyclical improvement in earnings growth in the second half of 2014 and again in 2015. I think that we have the option of reform in emerging markets, as we've seen with Mr. Modi's election, the Indonesian election, and the hopes of the voters in Brazil, perhaps, later this year. All countries are trying to change their governments to make more market-friendly macroeconomic policies.

Finally, I think that investors have realized that they've been running underweight positions in emerging markets for a long time, and they're beginning to close their significant underweights in the face of improving news from the emerging world.

Oey: We often talk about emerging markets as one big asset class, but in fact it's very heterogeneous. Are there countries or areas that you like, and maybe there are areas that you're concerned about?

Smithie: That's right, Patty. I think there is a tendency to consider emerging markets as a single homogeneous block; whereas, of course, it's not. And although the performance at the index level has been static for the last three or four years, what you've seen is a large dispersion of returns within countries within that universe, and the reason is that many countries have performed better than others.

At EGA, we think there are plenty of investment opportunities throughout emerging and frontier markets, but we don't particularly like the way in which standard indices have been constructed that give investors too great a concentration in large countries and sectors that have not been performing particularly well, and inadequate exposure in domestic-demand parts of emerging economies that have been doing extremely well indeed.

So we're always advocating the idea of emerging-market domestic growth and investors getting exposure to long-term superior domestic growth in emerging and frontier markets--not necessarily in the traditional weights that they would find with standard indices from better-known index providers.

Oey: You touched on frontier markets, and it has been a hot topic, as frontier markets have done really well over the last 18 months. Can you talk about how risky is this asset class? Do you have a product that provides exposure to frontier markets?

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Smithie: It's an excellent question, Patty. People, I think, avoid frontier markets because of the perceived risk, and I think what the risk entails is a risk of relative ignorance about the asset class.

Risk as defined by standard deviation returns in frontiers has been very low. The risk of losing your investment can be diversified away by buying a basket of countries or exposure to a basket of countries and industries. And I think that the last risk that investors always have in mind is liquidity risk, and there is a particular concern with liquidity that has arisen since the global financial crisis.

At EGA, we have a couple of strategies for investors to take advantage of. We have a partially liquid frontier product that's consistent with the small size of the asset class, which is our frontier market core solution, and we have a strategy called Beyond BRICs, where we've combined small emerging markets with frontier markets in a single developing market solution that offers both growth, daily liquidity, lower standard deviation of returns, and low correlation. So we think that investors should be looking for uncorrelated growth within emerging and frontier markets as a whole to support the asset allocation in global portfolios.

Oey: This Beyond BRICs fund is interesting because there are so many countries in it, and all those countries are actually very different. So, held together in a portfolio, it helps lower standard deviation. Is that right?

Smithie: That's right. So we are looking for low inter- and low intra-asset class correlations. What we've observed over the years is an increase in correlation amongst all asset classes. So emerging markets used to be 0.5, 0.6 correlated to the rest of the world. Come the financial crisis, the correlation rose to 0.8, 0.9, and the correlations have remained higher ever since.

Now the benefit of investing in emerging markets is, first, that you get a superior growth rate, but second, you're looking for diversification. And diversification means that you want assets that are lowly correlated with your existing assets. And we think that smaller emerging and frontier markets fulfill the diversification requirements through these lower correlations.

Oey: A lot of investors look to emerging markets for growth, but actually what we've seen is that GDP growth doesn't automatically translate to strong stock market performance. Can you talk about that issue? How should investors view GDP growth as it relates to stock market performance?

Smithie: It's an excellent observation, Patty, and one that has been increasingly recognized by investors in equity markets: You're not buying GDP growth; you're buying corporate earnings growth, and markets do well where earnings grow.

Within the emerging world, we know that returns over the long run come roughly two-thirds from earnings growth and roughly one-third from dividends, and you don't get returns from high GDP growth. So investors, I think, have to be very selective in making their emerging-market investments. We've seen very high GDP growth in China, but we've seen very poor corporate profitability and very poor corporate earnings growth. And the same has been true in Brazil.

So, we think that investors should be discerning and seek out sustainable growth and profitability. Disregard headline GDP growth, but look for sustainable corporate earnings growth, and where we've seen that over the last few years, funny enough, has been in the smaller countries, in the domestic sectors. And if investors are prepared to take non-standard index positions in parts of the market that are growing, you can still get very good returns in the emerging markets, despite the flat overall performance of recent years.

Oey: Thanks for all your insights, Nick.

Smithie: Thanks for having me, Patty.