Accessing emerging economies via developed markets

2019 Global Investment Conference coverage

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Simutin / Michelle Quance photographyIn a world where opportunities in emerging markets are limited, pension plans can look to access underlying emerging economies rather than the publicly traded markets themselves, said Mikhail Simutin, associate professor of finance at the Rotman School of Management and associate director of research at the International Centre for Pension Management.

Emerging markets hold promise for diversifying portfolios and improving risk-return trade-off, but those opportunities have been diminishing and those correlations with developed markets have been trending up, Simutin said when speaking at Canadian Investment Review‘s 2019 Global Investment Conference.

There’s also a lack of depth in emerging markets, Simutin said, listing Morocco as an example: “It has about 83 publicly listed firms on the stock exchange so if you’re trying to diversify into Morocco, an emerging market, this is a very narrow window through which to access the economy. It’s going to be like an elephant drinking from a cup if you’re trying to access these low-depth markets.”

There are also weak shareholder rights and political instability in many developing countries, Simutin said. And, when markets go south, emerging market publicly traded stocks typically fall much more than stocks in developed markets, he added.

“These are some of the challenges that you have to keep at the back of your mind as you’re thinking about trying to exploit these diversification opportunities in emerging markets,” he said.

Yet, there is another way for plans to diversify into emerging countries while avoiding some of the aforementioned concerns and maintaining the safety and transparency of developed markets, Simutin said. This can be done by looking to companies in developed markets that do business within specific emerging countries.

For example, an investor can buy an Australian company that sells iron ore to Indonesia and get indirect exposure to Indonesian infrastructure projects, he said.

At a simple level, if there are two firms in Australia that sell to Indonesia and Morocco, one with $2 million of exports to Indonesia and $1 million of exports to Morocco and the other with $1 million of exports to both Indonesia and Morocco, if an investor buys the first firm and short sells the second firm, the Moroccan piece cancels out and what it is left with is pure exposure to a single emerging economy, which is Indonesia.

Investors can develop indices using this approach, which still has risks, but when a downturn happens, this strategy doesn’t do as poorly as emerging markets themselves, Simutin said.

“You have the safety and transparency of the developed markets, while accessing emerging economy activity. You have the political stability and shareholder standards that are up to an arguably higher level in developed markets, while again accessing what’s happening in the emerging economies.”

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