Don’t Get Left Behind
Are emerging markets missing from your portfolio?

By Shaw Wagener, chairman, Capital International, Inc.

Just as American businesses are focusing on developing countries as a core part of their future growth, the same should be true for investors; however, this has not been the case so far. Ask any major corporation or any thoughtful economist and they will tell you the key to their long-run strategy or to world economic growth is emerging markets. This concept of countries on the periphery growing as their populations aspire to higher living standards and progress is not new, it’s been going on for centuries. Investors are behind the real economy regarding their asset allocation to emerging markets. Today they can get exposure through mandates with varying degrees of anticipated return and volatility that will help increase diversification, reduce risk, and minimize overall volatility. In fact, not having exposure poses the biggest risk to investors.

DC plans under-exposed
So where are we today? The market cap of Emerging Market companies in the All Country World Index (ACWI) is 8%. If one included all emerging market companies and not just those in the index these companies would represent 15% of ACWI. That is a big active 'bet' against these companies that have an outstanding future and strong fundamentals. A 2005 study published by Hewitt suggests that only 12% of companies offer a dedicated investment in emerging markets in their defined contribution (DC) plan. For those companies that offer a dedicated emerging markets investment option in their DC plan, only 2% of total plan assets are allocated to emerging markets, and emerging market equity only represents 1% of total DC assets. Meanwhile 56% of all DC assets are concentrated in domestic equity, stable value, or company stock. This under-representation is not isolated to DC plans. Institutional plan sponsors have inadequate exposure to emerging markets too as outdated perspectives on potential risks and volatility drive investment decisions.

Despite the recent volatility in emerging markets, the strategic investment case for the asset class remains strong. The emerging markets represent a dynamic universe composed of diverse industries and markets with nearly three billion people. Economic growth is still robust in most emerging markets and is much less dependent on the U.S. and other developed markets compared to even five years ago. Emerging market economies have expanded at more than twice the growth rate of developed economies and the quality of economic development has improved substantially with a much wider base of industries, rather than concentration within one or two areas of the economy. Important trends such as privatization and the listing of family-owned businesses have driven market expansion, and the total estimated investable universe is set to grow from $29 trillion today to $48 trillion over the next two decades. Witness that emerging market IPOs raised over $90 billion in 2006, with 50% of that in China alone. In 2050 four of the five top economies will be emerging markets such as Brazil, China, India, Russia and Mexico.

There is no doubt that over the last couple of years, the easy availability of credit globally and booming commodity prices has created some frothiness in emerging markets. However, broadly speaking, investors recognize the enormous improvement in most emerging market economies, including declining public sector debt, current account surpluses and a surge in foreign exchange reserves created by prudent policymaking, better fiscal discipline and efforts to enhance international trade. Corporate profitability and earnings growth have also increased dramatically, underpinned by relatively attractive valuations such as price-to-earnings and price-to-book, which remain at 1997 levels. As such, the recent performance of emerging markets is just getting back to trend.

Significant changes have occurred over the last 20 years that have provided the foundation for multi-year superior growth that has not been seen before. As such, emerging markets should be a permanent, strategic, and growing part of investors’ asset allocation.

To view Shaw Wagener's presentation, click here.