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Emerging Market Equities Allocation Framework (GMO)

GMO White Paper: Revisiting the Traditional Emerging Market Equities Allocation Framework, July 2017

Traditional approaches to determining an optimal EM allocation have remained static

  • 2017 marks the 37th year since Antoine van Agtmael referred to a selection of developing countries as “emerging markets” and the 29th year since MSCI first devised an EM equities index
  • In 1993, MSCI EM index had an investable market value of $300Bn and today, the Chinese internet sector alone is valued at $820Bn
  • However, when it comes to consensus view on analyzing the EM asset class, the more things change, the more the industry and its insufficient analysis appear to remain mired in the past
  • Over the last 20 years, consensus has guided them toward a top-down approach to EM valuation:
    • Asset class valuations relative to history
    • Absolute valuations
    • Asset class valuations relative to developed markets
  • Given the evolution of the asset class, believe each of these three metrics now result in an inadequate assessment of fair value
  • Measuring valuations relative to history has some merit but must acknowledge that the composition of the asset class has changed drastically over the last 20 years
    • Financials contribute 35% of earnings today vs 15% in 2003
    • Earnings from commodities have shrunk from 44% to 15%
    • Regions such as Latin America and CEMEA have been replaced in importance by Northeast Asia
  • Looking at the EM aggregate index on a standalone basis masks its deficiencies
    • Index has significant embedded risks in the form of single-country earnings risk (China-related earnings constitute over 41% of index earnings); so-called “government-linked companies”; and the overarching weight of financials (risk of buying highly-levered earnings stream because financials represent 40% of the index’s book value)
    • When you buy the EM index, how much of what truly drives emerging markets – rising consumption of middle class, favorable demographics, evolving sociopolitical institutions – are you really getting? (Answer: Very little)
  • Comparing the valuations of a disparate group of 23 countries to the more homogeneous developed markets group and subsequently assigning a premium or discount to growth results is perilous if the comparison is blind to the varying economic volatility of the two groups

A risk-based approach to assess asset class attractiveness

  • Since 1990, an average EM country has experienced 5 times more drawdown than S&P
  • Within the EM index, each country has fallen more than 20% an astonishing 22 times (S&P on the other hand, has fallen by over 20% only 4 times since 1990)
  • Not only are drawdowns frequent in EM but the time it takes to recover capital is also substantial
  • As EM investors, priority is to ensure return of capital first
  • We have devised an aggregate risk metric which is built by using country-level assessments of the following 4 variables:
    • Dependency on external savings to identify balance of payment risks
    • Above-trend growth to identify economies growing in an unsustainable manner
    • Currency valuation because currency shocks translate into economic shocks and detract from returns for developed market-based investors
    • Political uncertainty to anticipate event risks
  • From 2002 to 2014, there were times when the EM index could be classified as “cheap” and those where the index was “expensive” – for the purpose of this analysis, cheap denotes when Shiller P/E was less than historical average while expensive was when Shiller P/E was greater than historical average
    • Strategy based on allocating purely by valuation gets an investor only a median annualized returns of 14% based on a 3-year holding period
  • If you use the identical value assessment and overlay it with an assessment of risk based on data calculated from our EM risk indicator as defined by the 4 variables mentioned above, median annualized return was 2x what a valuation-driven strategy would have delivered
  • Avoiding EM when they were expensive and in the high-risk category paid off extremely well
  • Currently, we believe EM risk is lower today and valuations are fair

Conclusion

  • Frequent and significant drawdowns in EM can lead to a permanent impairment of capital
  • Taking a risk-based approach to evaluation of the asset class can guide allocators as to the timing as well as whether to opt for a broad-based EM strategy or a more concentrated strategy focused on a handful of country/sector combinations
Image Source: FactSet, GMO
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