Emerging Markets Gaining Appeal for Returns and Diversification - But Countries Matter

NEW YORK, June 16, 2015 /PRNewswire/ -- With U.S. equities at historic highs and many fixed income yields close to zero, many investors are looking abroad for better returns. One area of increased focus – after several years on the bench – is emerging market (EM) equities. Investors are increasingly seeking the potential benefits of EM's diverse landscape, with higher expected growth potential.

"The S&P 500 is up 2 percent this year, stalling after a five-year rally," said Michael LaBella, a portfolio manager with Legg Mason affiliate QS Investors. "Emerging markets are up 6 percent over the same period. Investors are noticing."

"A strategic tilt will play out over the next five, 10, 15 years," Mr. LaBella said. "Over 85 percent of the world's population now resides in EM countries. Their share of GDP is nearly 40 percent – and climbing – with annual growth rates double those of the developed world. It's just an exciting place to be."

"People keep asking me when the U.S. is going to start growing above 2 percent again, and I tell them they're looking in the wrong place: EM is growing over 4 percent right now."

While most investors agree on their long-term merits, emerging markets have proven to be a challenging place to invest. Both passive and active products tend to concentrate heavily in the biggest and most developed countries. This frequently leaves investors with neither the diversification nor the growth they were after.

What's the solution? QS Investors counsels a diversified and unconstrained approach.

"Equity investors have a large home-market bias so emerging markets can offer excellent diversity of returns," Mr. LaBella said. "But to unlock the full potential benefits of EM, investors should consider moving away from the major EM indexes. They are too heavily weighted in things like commodities and the BRICS, which have high correlations to developed markets. Instead investors should look for more balanced exposure."

After a 10-year period of enormous excitement about China and the commodity super cycle, most EM indices have become heavily weighted to a small number of countries and sectors. QS Investors believes countries that are not as closely tied to the developed world's business cycle – like Poland, Chile, Indonesia, Malaysia, the Philippines, Turkey and the Czech Republic – should be considered by investors seeking more diversified EM exposure.

"That way they can potentially participate in the EM growth story with the possibility of being better protected from macro surprises, like falling oil prices or another taper tantrum," Mr. LaBella said.

The MSCI EM index is comprised of 23 countries, but just seven (dominated by the BRICS) account for nearly 80 percent of the weight. Three sectors – financials, commodities and technology – account for over 60 percent. These did well over the last EM bull run, but investors should ask whether this is the best positioning to capture growth opportunities for the next cycle.

"Investors don't usually pay a lot of attention to country or sector diversification when it comes to buying index exchange-traded funds ("ETF") or active mutual funds, but macro factors really matter when it comes to EM," Mr. LaBella explained. "Just think of what drove performance last year: Russia invading Ukraine, reformist election wins in India and Indonesia, oil prices collapsing. They all had significant impacts on returns."

"Most investors understand the benefits of stock diversification. They would be pretty concerned if seven companies, which were mostly oil sensitive, constituted 80 percent of their investments. Investors need to expand that logic to include macro diversification."

"The EM landscape contains a diverse universe across different regions, political systems, demographics, and stages of development," Mr. LaBella said. "Yet a heavy bias towards bigger and more developed countries leaves investors with many missed opportunities for growth."

How significant are those missed opportunities? In 2014, eight of the top 10 best performing countries had some of the smallest weights in the index. Over the last five years, through the end of March 2015, the Philippines, with only a 1 percent weight in the index, outperformed all of the other countries in the MSCI Emerging Markets Index.

It can be hard to predict the next top performer in any context. Who will be the next Pablo Picasso? The next Tom Brady? This is why investors should consider reaching outside the standard tool set for new ways of unlocking value. QS Investors follows a three-step process.

"First we aim to uncover macro themes," Mr. LaBella explained. "Then we diversify across them, adapting to changes in the market environment. Our process is top down and designed to achieve true diversification. Sometimes even a portfolio that is broadly diversified across multiple countries and sectors can hide concentrated macro risks."

"Some countries share commonalities, like Brazil and Russia, with their dependence on energy and commodities. Others are very different: Turkey and India being much more domestically focused, for example. By uncovering areas of common economic sensitivities, we are better able to map potential market concentrations."

While energy and commodity sensitivities are obvious and well-known, other relationships can be less visible. As an example, during the tech bubble of the 1990s, information technology companies grew to a large proportion of the EM Index. This mirrored what was happening in the U.S. Less apparent was that other sectors were being swept along into the dotcom frenzy. Investors lumped telecoms, media and retail companies with IT ones, spurred by global excitement about building out broadband infrastructure, new media channels and the  prospect of millions – possibly billions – doing more shopping on the Internet.

As the chart illustrates, IT grew from 2 percent of the index to nearly 25 percent in just over five years. This posed a significant concentration risk for investors. Less known was that these other seemingly unrelated sectors increased an investor's "dotcom" exposure to nearly 50 percent. 

INDUSTRY AND SECTOR WEIGHTS IN THE MSCI EMERGING MARKETS INDEX
December 1994 – December 2007

Photo - http://photos.prnewswire.com/prnh/20150615/223257 

As IT exposure ballooned, correlations of these seemingly unrelated industries grew as well.

24-MONTH ROLLING CORRELATIONS TO IT SECTOR
December 1994 –  December 2004

Photo - http://photos.prnewswire.com/prnh/20150615/223258 

"This is when the market crashes and you hear people on cable TV proclaiming diversification is dead, but diversification was not dead," Mr. LaBella said. "Investors were not truly diversified.  Nearly half of their funds were in the same global theme."  

Diversification may be the only "free lunch" in investing yet it is poorly served by many market-cap indices. Investors can do better.  

EM equities can provide part of the solution, with less correlated equity opportunities that can also offer higher potential long-run returns. However investors have to pay close attention.

"We try very hard to be comprehensive in our analysis and anticipate risks, macro and micro," Mr. LaBella said. "We dig deep into EM countries, and sectors. And yet the ironic truth is that diversification can help investors capture opportunities and manage against risks no one sees coming."

About Michael J. LaBella, CFA

Portfolio Manager Michael LaBella has been with QS Investors since 2010. He joined the firm from Deutsche Bank, where from 2005 to 2010 he was a portfolio manager for the quantitative strategies group, and an institutional sales trader in the corporate and investment bank. A Chartered Financial Analyst, he earned a B.S. in Financial Economics from Binghamton University.

About QS Investors

A wholly-owned, independently-managed affiliate of Legg Mason, Inc., QS Investors, LLC was formed in 1999 as the quantitative platform of a global asset manager. As an investment firm providing asset management and advisory services to a diverse array of institutional clients, QS Investors delivers disciplined, systematic solutions that address clients' complex challenges. The QS team has developed unique approaches to integrating quantitative and behavioral investment insights and dynamically weighting opportunities in response to changing economic and market conditions. Risk identification, assessment and management are intrinsic to their process. Based in New York, QS Investors offers a broad spectrum of strategies to clients worldwide, including actively managed U.S. and global equities, liquid alternatives and customized solutions.

About Legg Mason

Legg Mason is a global asset management firm with $707 billion in assets under management as of April 30, 2015. The Company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (symbol: LM).

© 2015 Legg Mason Investor Services, LLC, member FINRA, SIPC. QS Investors, and Legg Mason Investor Services, LLC, are subsidiaries of Legg Mason, Inc.

Views expressed are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Predictions are inherently limited and should not be relied upon as an indication of actual or future performance. As a result, Legg Mason cannot guarantee the accuracy or completeness of any statements set forth in this article. All information was current at the time of this publication and is subject to change without notice. This article should not be deemed as an offer to sell or a solicitation to buy the securities mentioned in this article.

Equity securities are subject to price fluctuation and possible loss of principal. International investments are subject to special risks including currency fluctuations, as well as social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

BRICS
BRICS is a grouping acronym that refers to the countries of Brazil, Russia, India, China and South Africa which are all deemed to be at a similar stage of newly advanced economic development.

S&P 500 Index
S&P 500 Index is an unmanaged index of common stock performance.  Please note an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.

Gross Domestic Product (GDP)
Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

MSCI EM (Emerging Markets) Europe, Middle East and Africa Index
The MSCI EM is a market capitalization weighted index that is designed to measure the equity market performance of the emerging market countries of Europe, the Middle East & Africa. Please note an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.

INVESTMENT PRODUCTS: NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE

SOURCE Legg Mason

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