Yale Prof: How to Tap Emerging Markets | Chief Investment Officer

(February 28, 2012) — High returns with lower than average volatility are possible from emerging markets through a certain subset of listed equities, according to a Yale professor.

Affiliate companies of large multinationals that are listed in developed markets produce a better return than independent, locally-listed emerging market companies, according to Martijn Cremers, Associate Professor of Finance at Yale School of Management.

Cremers said: “These affiliates combined the higher performance with lower volatility, and especially lower down‐side volatility. Their performance during the financial crisis was particularly good, compared to both their local markets and the developed markets, and especially so in Asia. We offer two main reasons for this outperformance: improved corporate governance and a stabilizing role of the parent companies.”

Cremer said these factors had seemed critical during the financial crisis and provided affiliates with “a clear comparative advantage over their local competitors that should endure in the foreseeable future”.

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The paper showed emerging markets had generally outperformed developed nations in the 13 years to the end of June 2011. The MSCI index tracking emerging markets in Asia had risen 15.1%; in Europe, the Middle East and Africa it was up 14.6%; and in Latin America the index was up 19%. This compared to the MSCI World, tracking all countries, had risen only 5.2%.

Aberdeen Asset Management, which commissioned the study, said there were 92 such companies across the emerging world and drew the example of grocery producer Unilever. The company has listed affiliates in India, Indonesia and Pakistan in which it has stakes of 37%, 85% and 75% respectively.

Aberdeen said: “Over the thirteen years from June 1998 to June 2011, a period chosen for its balance between sample size and history length, the listed affiliates returned 2,229%. This compared with total returns of parents, local markets and parents’ markets of 407%, 1,157% and 147% respectively.”

Earlier this month, a research arm within Deutsche Bank warned that investing in emerging market-listed equities was no solution for investors seeking high returns. The paper, released by the bank’s ‘cash return on capital invested’ (CROCI) basis, said that despite annual GDP increases for many of these nations sitting comfortably in double digits, emerging market equities showed a lack of real earnings growth.

Peter Elston, Head of Asia Pacific Strategy & Asset Allocation, commented on the paper by Cremers: “While there will continue to be home grown success stories, the strong corporate culture of affiliates is a competitive advantage for the companies in this select group is hard to ignore. Opportunities in emerging markets are perhaps more attainable than ‘stay-at-home’ types think.”

From aiCIO Magazine's February Issue: Like printed magazines, the demise of defined benefit has long been predicted. We're still waiting for those prognosticators to be right.

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To the frigid hinterland of Chicago I ventured in early January for a five-day executive education program at Medill, Northwestern’s vaunted School of Journalism. The intensive course—taken alongside other business-to-business magazine publishers and editors, mostly (oddly enough) from the farming sector—covered a canyon of topics: social media, business exit strategies, integrated selling, and branding. Every small topic, however, fed into one large one: How to survive in a seemingly shrinking and troubled industry.

The discussions at Medill were reminiscent of the defined benefit world. Ever since aiCIO founder Charlie Ruffel and a select few others accurately predicted in the mid-1990s that “defined contribution” was the future, lesser prognosticators have been dismissing these gargantuan pools of capital. “They’re done,” they’d say. “Why pay attention?” How wrong they were, and are.

For the same reason that magazines and media still matter—you’re reading this letter, aren’t you?—defined benefit still matters. Forty years from now, people will be consuming financial journalism; at the same time, there will still be trillions of dollars in defined benefit capital invested in the markets, and thus moving them.

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The problem is that neither industry is great at adapting. One needs only to look at the graveyard of magazines—the likes of Condé Nast’s Portfolio and Global Pensions in the ground and Time and Forbes near burial—to see just how poorly media companies did at adopting new models of delivery and financial reality. Similarly, the “perfect storm” of 2008—which, as is clear to pretty much anyone who thinks about it, was not a perfect storm at all but an all-to-common occurrence—showed the failure of defined benefit pension adaption. If loss of capital is the fundamental risk for a pension plan, the vast majority of pension plans utterly failed to understand and adapt to new asset allocation models (think liability-driven investing), risk management systems (think dynamic asset allocation), and governance models (think Canadian and Dutch pension and endowment structures).

So how do both magazine editors and defined benefit chief investment and executive officers go from A to B, from old models to new? If I had the silver bullet, I might be teaching at Medill rather than taking courses (or maybe not), but here is my root solution: take risks. Not risks in the vein of blindly upping equity exposure or piling billions into illiquid alternatives, but risks along the lines of exploring new models, of testing the assumptions of ideas such as wider bands on asset allocation, risk parity, and tail hedging. Because, let’s admit it, we’re both in troubled industries and we won’t all survive. But some will. And it’s my bet that those that do will be the ones taking intelligent risks and pushing the boundaries of what our peers—be they in journalism school or your national pension organization—deem normal.