Insights, The Bridge
Jason Hsu, PhDScroll down
My interest in emerging market investing is largely driven by my personal experience.
My parents participated in the spectacular growth of Taiwan, where they saw their annual income increase from $200 to $20,000 over a span of 10 years, where real estate values increased 100x and the stock market produced a cumulative return of 20,000%. My wife experienced a similarly breath-taking increase in income and wealth growing up in China. But not all emerging markets have been so fortunate.
When I was studying economic growth theory, my greatest curiosity was around why some emerging markets “emerge” but others do not. What are the factors that dictate success? What types of growth models are sustainable? Is there a template that works for all? The more I learned about these markets, the more I asked whether their idiosyncrasies—their size, risks, returns, politics, financial institutions, state-ownership, etc.—make them foundationally different not just from developed markets, but also from each other.
Many investors rely on me for China research, but the same research process has proven fruitful when applied to other emerging markets. Investors and managers have historically viewed EM as one homogeneous basket of assets. They’ve imagined the miracle story of Taiwan and South Korea would inevitably repeat in other EM countries. But these countries are not homogenous, and the idea that the same story will repeat ad infinitum couldn’t be further from the truth. The disparate nature of emerging markets explains why many EM investment strategies have, for so many years, disappointed investors.
Despite the disappointment, EM remains a significant allocation in many portfolios. Are we just hopelessly romantic about the growth potential of exotic markets? Or are we intelligently seeking out opportunities to buy companies buttressed by low costs and a hungry young labor force? The central question I hope to answer for you today is this: is there a better way to buy emerging market opportunities?
In this article, I will 1) explain why EM has historically disappointed so many investors; and 2) explore the future of EM investing. As for me, I’m convinced the future of EM is worth the weight.
For decades, investors have had an intuition that EM is an important part of a diversified portfolio. But the results have been disappointing. What is going on?
Problem 1: Inconsistent Growth
First and foremost, EM has failed to deliver broadly sustained growth. Some Asian markets have been rewarding. But other markets—like Latin America and Eastern Europe—have failed to reach escape velocity. Along with idiosyncratic issues, these disappointing economies have been hampered by a cycle of commodity booms-and-busts.
In this sense, our intuition has failed us. Although individual EM countries have experienced growth, the category as a whole has been unreliable, with most growth in EM portfolios coming exclusively from Asia.
Problem 2: GDP Doesn’t Always Translate to EPS/DPS
A second (and possibly larger) problem is that, even where GDP grew as expected, that growth did not always translate to stock returns. In fact, my and others’ research has demonstrated that GDP growth is a flat-out unreliable predictor of country-level stock returns.1 What truly matters to investors is not an overall increase in economic output, but rather growth in listed companies’ earnings per share (EPS) and dividends per share (DPS). EPS and DPS represent the value that ultimately flows to shareholders.
Why doesn’t growing GDP translate to growing EPS and DPS in emerging markets? The answer is relatively simple when you think about it. Unlike in developed markets, listed companies in EM are not representative of their underlying economies.
In some cases, the businesses driving GDP growth may be too small to be listed; but more often, companies choose to remain private due to underdeveloped regulatory, financial or investment infrastructures. Compounding this unfortunate situation is that the companies most likely to list in emerging economies are state-owned enterprises—institutions not generally known for their efficiency and profitability.
Here again, our intuition has failed us. Our intuition correctly tells us there must be high-performing companies driving growth in emerging economies. But while that may be true, those companies are more likely to be small or unlisted. Which, of course, means they aren’t in your EM portfolio.
Problem 3: Lack of Diversification
Perhaps the most intuitive case for emerging markets would be its diversification value. After all, diversification is the only free lunch in investing. Diversifying into EM should at least provide this fundamental value, right?
Once again, our intuition has mostly failed us. As it turns out, EM as a broad category has been very high beta. This means that when US markets performed poorly, EM fared even worse.
My research suggests this happens for two primary reasons. First, most of EM is primarily dependent on US capital. In crisis, US flows gravitate towards quality, which starves even the best EM companies. Second, EM relies heavily on US consumption. When the US stops consuming, export-oriented EM economies are hit hard. This one-two punch has eroded much of EM’s diversification benefit in recent years.
Conclusion: The Old Approach to EM Is Broken
Let me recap the trifecta of problems I described above.
Our intuition tells us that 1) EM is growing, 2) we can access that growth through stock markets, and 3) EM exposure will diversify our portfolios. But in practice, EM growth has been uneven. Even where there has been growth, it hasn’t always been reflected in the stock market. And rather than support diversification, EM’s high beta has hurt—rather than helped—investors seeking diversification. Together, these issues have made many investors question whether EM is worth the weight in their portfolio.
Which begs the question: Is there a better way?
Let me answer my own question: Yes.
There is a better way to invest in EM, and I’m confident the future of EM is bright. But becoming a better EM investor begins with understanding and articulating the primary benefits we expect from an EM allocation.
Most investors want their EM exposure to:
So, how do we design our EM exposure to achieve these objectives while avoiding historical pitfalls?
Recommendation 1: Avoid “One-Size-Fits-All” Passive Indexes
Those who know my background may be surprised by this recommendation. Before I turned my focus to emerging markets about 15 years ago, I was known primarily for my contributions to index-based investing. In fact, I probably owe my career to the large and passionate passive community, led by my late personal idol, Jack Bogle.2 In many investment circumstances, a passive approach makes great sense.
But first-and-foremost, I follow the data. And my research suggests that passive EM strategies are especially susceptible to the pitfalls of EM investing over a long time-horizon. This is because emerging economies exhibit local nuances that make them difficult to approach passively with a “one-size-fits-all” approach; they are simply too inefficient and idiosyncratic to be accessed this way.
Recommendation 2: Look for Corporate Earnings Growth
My and my colleagues’ research established that GDP growth does not translate to returns in all emerging economies. For example, from 1988 to 2019, countries like Argentina, Jordan, Brazil and Portugal experienced negative mean real EPS growth despite positive GDP. In fact, China was the only EM economy where EPS kept pace with GDP during this period.
Adding additional complexity is that each EM country may have unique characteristics that impact how to access its growth. For example, the growth rate in Chinese corporate earnings described above is only for onshore listed companies. Offshore Chinese stocks—a group commonly utilized by passive strategies for “China exposure”—saw EPS grow at a much lower rate over the same period. This is largely because offshore Chinese stocks are heavily skewed toward state-owned companies and mature mega caps. Investors relying on offshore China stocks in their EM portfolios would have missed out on much of China’s growth over the past 25 years.
In the end, managers do investors a disservice if they allocate to EM based solely on market cap or GDP. A better way to approach EM is to identify those markets where there is sufficient regulatory, financial and investment infrastructure available to support EPS/DPS growth—not just GPD growth—and to access that growth strategically.
Recommendation 3: Look for Low Correlations
If a primary benefit of EM is meant to be diversification, then investors should ask whether their portfolio is delivering on that promise. For many investors, it is not. The reason is that EM portfolios often avoid the very markets and sectors that have provided the greatest diversification benefit. If investors want diversification, then they need to focus on EM securities that are least correlated with their developed market holdings.
For example, as noted above, most EM portfolios obtain China exposure primarily through offshore-listed securities. Unfortunately, these securities are disproportionately represented by China tech, which is why China tech—despite the regional diversification—is still highly correlated to US FAANG stocks. See the chart below, which Josh Brown provided for discussion during my recent sit-in on The Compound and Friends podcast. It is ironic that EM strategies overweighting offshore China end up overweight tech. Investors in these strategies were seeking diversification but instead took on concentration risk!
The simple truth is that we talk so much about “EM” as a category that it’s easy to overlook the diversity of its constituents. For example, as you can see from the following chart, the correlation between U.S. equities and other DM stocks is quite high at 0.89. EM ex-China and offshore Chinese stocks do provide some diversification benefits, with correlations to U.S. shares of 0.77 and 0.63, respectively. But onshore China (so-called “China A shares”) is in a league of its own, with a surprisingly low full-sample correlation of just 0.39.
Recommendation 4: Look for High Retail Participation
Investing for alpha is a zero-sum game, and because there must be both winners and losers, we should reasonably expect experienced managers to have a meaningful edge against retail traders. By way of analogy, we’d expect Lebron James to lose an occasional game to other NBA players; but we’d expect him to beat the vast majority of amateurs.
The same is true in investing. The first chart below ranks a set of developed and emerging markets by estimates of retail investor participation. The second chart then plots the average returns in each market from simple quant strategies—including popular factors such as, Value, Quality, Low Risk, and Momentum—over the last five years. What you’ll likely conclude from these charts is that the “alpha reservoir” in a market is strongly correlated to the volume of retail participation in that market.
A few real-life examples might prove instructive in understanding why increased retail participation leads to increased alpha opportunity. Let’s look at two of my favorites from China, the EM economy with the most robust financial infrastructure—and highest rate of retail participation. In both examples, retail investors succumbed to behavioral biases that are irrational but also predictable.
My first example comes from shortly after the 2016 U.S. Presidential Election. Following release of the results, onshore Chinese investors piled into a stock whose name sounds like “Trump Wins Big,” even as they sold off a stock whose name sounds like “Aunt Hillary”.
In a more recent example, Chinese retail investors watching the 2022 Winter Games—which were airing during trading hours—saw that Chinese freestyle skier Eileen Gu was on track to win gold in the Big Air event. They promptly piled into a stock whose name in Chinese, “Yuanwanggu,” was phonetically similar to the phrase “Look out for Gu”.3 This random IoT company’s stock went limit up before Gu’s final run was finished.
It might go without saying, but retail irrationality like this makes for good stock picking. And while these two examples are unique to China, the phenomenon certainly isn’t. As a behavioral quant, I am attracted to the emerging markets where retail-riven anomalies are most likely to occur, and Rayliant has developed a “retail trading signal” that seeks to capture these mispricings. But at a minimum, EM investors should consider over-allocating to EM markets with high percentages of retail traders who are prone to make mistakes.
All this may sound intuitive. However, it’s not something passive EM strategies have historically considered. The result, of course, is that passive EM strategies are often under-allocated to the very markets that have the greatest alpha potential.4
Conclusion: The Future of EM is Active
There are material differences within each emerging market that affect how one might access their growth, but passive strategies do not consider these differences when making EM investment decisions. EM investors will continue feeling disappointed if they do not approach EM investing differently from DM investing.
This is why the future of EM is active. And when I say “active,” I don’t necessarily mean fundamental stock picking. What I mean by “active” is an approach that strategically accounts for the structural and behavioral differences among diverse emerging economies.
In Part 1, I explained why old EM models have disappointed many investors; in Part 2, I outlined a better way to approach EM for the future. But questions remain. Is it worth it? And is now the right time for EM? This probably won’t surprise anyone, but I believe now is the perfect time for EM.
Let’s start with the basics: EM is cheap. It’s cheap relative to other markets; and it’s cheap relative to its own history. The chart below compares price-to-earnings ratios for indexes reflecting each of the following markets:
Of course, cheap can get cheaper. Outside of EM Asia, EM is arguably distressed due to the rising cost of capital combined with a flight to quality. This region might not be out of the danger zone until the US begins yet another round of QE to inject liquidity, which reduces EM cost of capital and drives export growth.
EM ex-Asia’s dependence on easy US money is part of what makes it high beta. And EM Asia is cheap in large part because of the slowdown in China and the geopolitical tension in the region, which has cratered investor confidence. While US sanctions against China and the rhetoric around friend-shoring away from China have had minimal impact on the world’s largest factory, it has had enormous effect on investor sentiment, both global investors and domestic Chinese retail traders. The salient question is whether the negative sentiment reflects fear or actual risk?
I could write 10 more articles on this question alone. But don’t worry, I won’t bore you with it right now. For now, suffice it to say I think the fears about EM are far greater than the actual risks.
In fact, EM markets may be less risky today than at any point in the past. EM institutions are becoming more sophisticated, financial markets more mature, regulators more skilled, and EM strategies more tailored to the unique differences among individual emerging markets.
My final take? The future of EM is well worth the weight.
1 I recently discussed this in my paper “What Matters More for Emerging Markets Investors,” published in the Journal of Portfolio Management with co-authors Phillip Wool, Jay Ritter and Yanxiang Zhao. In addition, in one of the most comprehensive early studies on the topic, Ritter (2005) investigated 16 developed markets from 1900, and found no significant correlation between growth and stock returns; Ritter (2012) and Dimson, Marsh, and Staunton (2014) provided an update of that research and extended the finding to emerging markets.
2 As an aside, I had the pleasure of appearing last year on an episode of the excellent Bogleheads on Investing Podcast with Rick Ferri. I can’t say for certain, but I suspect I’m among the few active managers featured on this well-known program, or at least among the few warmly received. I hope Jack Bogle would have approved!
4 The most egregious example of under-allocating to alpha-laden markets is the approximately 4% allocation most EM investors make to onshore China. This is the country with both the most robust stock market and highest retail trading of all emerging economies. The alpha reservoir in onshore China should be deep, and indeed it is one of the rare markets where active fund managers regularly outperform passive approaches.
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