East Capital Pro Letter -
It is sometimes claimed that emerging markets (EM) are structurally underweight in investors' portfolios relative to developed markets (DM). The bias towards DMs may be explained more by home market advantages (ie. the investors are from the DM) and other implicit factors, rather than by fundamentals.
The numerical exercise below suggests that the current index weighting is seriously flawed and that the exposure to rapidly growing EMs should increase over time at the expense of less vibrant and more indebted DMs.
The MSCI All Country World Investable Market Index (ACWIM), which is thought of as a benchmark for a diversified global portfolio, suggests almost 88% exposure to DMs and 12% to EMs. But looking at the market capitalisation of the 45 markets included in the index suggests that the ratio should be 76/24, ie. a relative doubling of the EM exposure! The misallocation becomes even greater when comparing the underlying size of the economies. Today, DMs make up 72% of the global economy, a number expected to fall to 67% within five years.
The numbers would be even more striking if adjusting for purchasing power or if taking the fact that financial deepening is an integral part of economic development into account. A useful indicator of financial deepening is market capitalisation as a share of GDP, which is 86% in DMs and 70% in EMs using weighted averages.
All this suggests that investors using the ACWIM, which arguably is a relatively aggressive index, are 13% overweight in DMs and 97% underweight in EMs in relation to market capitalisation. The corresponding numbers for economic size are 18% overweight in DMs and 129% underweight in EMs.
Moreover, DM share of the global economy will fall 8% during the next five years, whereas the EM share will increase 20%, thus exacerbating the current misallocation.
The misallocation is even more striking when moving from EM/DM aggregates to the individual market level. Russia's weighting in ACWIM is 0.8%, but its market capitalisation, using the conservative $493bn according to Bloomberg rather than the more likely $850bn, suggests it should be 1.2%.
The Russian economy makes up 2.4% of the global economy today, a number expected to grow to 3.2% by 2014, indicating that the Russian market is 185% underweight in ACWI relative to the size of its economy today. The numbers are even more remarkable when studying the same indicators for other markets in Central and Eastern Europe included in the index, such as Poland and Turkey. The calculations suggest that the exposure to the Warsaw and Istanbul stock exchanges is 110% and 224% respectively under-weighted in terms of market capitalisation and 375% and 530% respectively underweight in terms of size of the economies.
Portfolio allocation is, and will continue to be, influenced by other factors than market capitalisation and economic size.
But the point here is that indices are much too conservative and investors are losing out in the short, but more importantly, the longer term. But what about the high degree of volatility in EMs? Well, EMs tend to move more than DMs in bull and bear markets, which is why a longer term perspective is key. ING is arguing that the 00s was a lost decade for DM equities, as it only returned 2% or 0.2% per year compared with 162% or 10.1% annually for EM equities. Even if the EM weighting in ACWIM has been more than doubled during this period, it is still much too low. On top of what the numerical exercise above suggests, the substantially higher economic growth, structurally lower debt and a bigger scope for financial deepening should make EMs increasingly more attractive.
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