Schroders’ Conway explodes EM ‘myths

Today, emerging economies contribute to over 50% of world GDP growth and this trend is only set to continue for the foreseeable future.

The increased significance of the emerging markets to global growth, underpinned by domestic demand driven growth and robust fundamentals, has led institutional investors to increasingly regard emerging markets as a strategic rather than a tactical asset class.

This shift in investor perception, which has been reflected by record inflows of over $95 billion into emerging markets equity in 2010, has led to a debate about the best method for investors to gain exposure to the emerging markets.

Myth 1: Investing in developed companies carrying out business in the emerging markets is better than investing in emerging markets companies directly.

Developed market companies are increasingly looking to the emerging markets to secure future growth, and corporates in many developed economies are generating an increasing proportion of their revenue from the emerging world, from around 9% in 1990 to almost 20% today

Investment in emerging economies by companies in the developed world is a growing trend. This is expected to continue as many multinationals are becoming reliant on emerging markets growth to generate revenue. For example, Unilever currently generates over half of its sales in the emerging markets, and Nestlé almost a third.

As a result of these trends, an investment in many developed markets stocks today is often an implicit investment in emerging economies and indeed some investors rely on this indirect route to gain emerging markets exposure.

However, such an approach means investors are still investing in companies with 50% or more of their income from developed markets. Not only does this dilute the investment, but investors may also pay a premium for developed companies’ operations in the rest of the world.

The weakness of this implicit approach is also reflected in performance returns.

Goldman Sachs has produced a BRICs Nifty 50 Developed Markets Index which comprises 50 companies from the developed markets that are believed to directly benefit from strong growth in the emerging markets and, in particular, the BRIC economies. The median exposure to emerging markets, as defined as a percentage of operating profit or sales, is 29% for the 50 selected companies. However, while the BRICs Nifty 50 Developed markets Index has modestly outperformed the S&P 500 over the past five years, the index has significantly underperformed the MSCI Emerging Markets Index.

FTSE has similarly created a developed multinationals index which includes multinationals that derive 30 per cent or more of revenues from outside their home economic region. The FTSE Developed Multinational Index has returned 32% over a 10-year period to 31 May 2011, while the MSCI Emerging Markets Index has returned 264%,

Investors have also justified gaining exposure to emerging markets through an investment in developed companies by suggesting it mitigates the perceived higher risk of emerging markets.

While by their nature developing economies are undergoing structural change which can lead to increased market volatility, we believe emerging economies today represent something of a safe haven, with low sovereign, corporate and household debt levels, high savings rates, large current account balances and huge foreign currency reserves. This is in contrast to the debt-ladened developed world.

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