Revisiting the Traditional Emerging Market Equities Allocation Framework
Introduction and key points
- As an asset class, Emerging Market (EM) equities have evolved considerably in the last 25 years, but traditional valuation metrics have remained static and should not be relied upon solely to guide allocation decisions.
- A thorough assessment of risk grounded in analyzing macroeconomic vulnerability, currency risk, and political risk should be a key determinant for your EM allocation.
- Combining valuation with an explicit risk assessment can significantly improve EM allocation decisions. Since 2002, an allocation to EM guided simply by Shiller P/E would have delivered robust median annualized returns of 14%. However, combining risk assessment tools with this simple valuation measure would have resulted in annualized returns of about 30% with fewer drawdowns over the same period.
- Our overall assessment of EM today is constructive: We believe risks are significantly lower and valuations are fair.
Most of our investors are familiar with (and hopefully appreciate) the multiple lenses through which GMO analyzes an asset class. Given our two-plus decades of experience in investing in EM, this paper focuses on complementing a traditional valuation-based framework with a risk-based approach that is designed to assess the attractiveness of the EM asset class. In GMO’s 1Q 2017 Quarterly Letter, Ben Inker states that the most important decision in determining long-term returns investors can earn is how much risk the investor is prepared to take.1 While the relationship between risks and expected returns is linear, he cautions that too much risk can also spell disaster for investors. We agree with the broad set of risks2 he identifies, and as dedicated, experienced EM investors we believe Ben’s warning is particularly relevant in the context of EM investing.
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. To state the obvious, much has changed in these past few decades. In 1993, the MSCI EM index had an investable market value of $300 billion. Today, the Chinese internet sector alone is valued at $820 billion, and several other country-specific sectors – the Taiwanese technology sector and Indian private banking sector, to name two – surpass the value of the asset class in its infancy. However, when it comes to the 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.
In our conversations over the last 20 years with asset allocators, we have noted that consensus has guided them toward a top-down approach to EM valuation. The three most common and seemingly robust metrics for valuations are:
1. Asset class valuations relative to history;
2. Absolute valuations; and
3. Asset class valuations relative to developed markets.
Aggregate metrics are a classic example of reliance upon heuristics – easy-to-understand rules and principles that simplify complex decision-making processes. Given the evolution of the asset class, we believe each of these three metrics – once perhaps an optimal set of heuristics – now result in an inadequate assessment of fair value.
First, measuring valuations relative to history has some merit, but we must acknowledge that the composition of the asset class has changed drastically over the last 20 years. The approach relies on comparing a current valuation metric such as the Shiller P/E to a historic average and extrapolating whether the asset class is cheap or expensive on this basis. For instance, financials contribute 35% of earnings today vs. 15% in 2003, while earnings from commodities have shrunk from 44% to 15%. Unsurprisingly, regions such as Latin America and CEMEA (Central and Eastern Europe, Middle East, and Africa) have been replaced in importance by Northeast Asia, whose contribution has grown from 40% to over 57.5% of earnings.
Second, looking at the EM aggregate index on a stand-alone basis masks its deficiencies. We believe the index has significant embedded risks in the form of single-country earnings risk (i.e., China-related earnings constitute over 41% of index earnings); so-called “government-linked companies” (companies with two masters whose earnings constitute 45% of the index); and finally, the overarching weight of financials (risk of buying a highly-levered earnings stream because financials represent 40% of the index’s book value). Therefore, when you buy the EM index or compare absolute valuations, how much of what truly drives emerging markets – rising consumption of the middle class, favorable demographics, evolving sociopolitical institutions – are you really getting? The answer is simple: very little.