Emerging markets’ risk declines, rewards remain attractive

Distant markets are cleaning up their acts at a time when the established markets are caught up in regulatory scandals

Advisors who put their clients into emerging-market investments always face the consequence of taking potentially high risks in search of equally large rewards. Yet, in recent years, the risks have been declining while the rewards have remained relatively high.

The downside varies widely across regions as well as countries, and can be placed into two broad categories: systematic and unsystematic risk.

Systematic risk cannot be diversified away but can be avoided. For example, investors can choose not to invest in a country because of its political, economic or regulatory regime. Unsystematic risk relates to investments in specific stocks or asset classes, and can be reduced through portfolio diversification.

In the past year, emerging markets have outperformed their more developed counterparts by a substantial margin, attracting a flood of investors wary of the low-return North American environment. The MSCI emerging markets free index climbed 55% in U.S.-dollar terms in the year ended Oct. 17, more than twice the 24.5% return of the developed markets’ MSCI world index. By comparison, the MSCI North American index gained 21.7% in the same period. Incidentally, emerging markets have outperformed developed markets over the past three- and five-year periods ended Oct. 17 (see table), indicating they can be more than hot short-term plays.

High returns, however, are not the only reason investors are pumping money into distant lands. They realize North American markets are not immune to scandals that have been typical of emerging markets. “There has been a significant improvement in transparency in emerging markets relative to the U.S.,” says Craig Millar, associate portfolio manager, international equities, Altamira Investment Services Inc. in Toronto. “Scandals such as Enron Corp. and WorldCom Inc., among others, and numerous cases of lax corporate governance, have eroded confidence in developed markets.”

The recent blows don’t mean the risk of investing in emerging markets is on par with that of the more developed markets. “The gap between emerging-market risk and developed-market risk is getting narrower,” says Chuck Wong, vice president and portfolio manager at Toronto-based Dynamic Mutual Funds Ltd. “Change has been gradual, especially in Asia, which has come a long way since the region’s 1997 financial crisis.”

Asia is now “enjoying the best of both worlds: growth and cheap valuations, combined with qualitative improvements, including better corporate governance, a more efficient regulatory infrastructure and improved risk controls,” adds Wong, a bottom-up stock picker. At a company-specific level, he sees “better financials, stronger balance sheets and more open investor communication and reporting.”

Millar, also a bottom-up investor, concurs, adding, “The key to higher prices in the region is partially the result of greater trust, which has contributed to better investor sentiment toward Asia.” He sees similar developments in emerging European and Latin American markets, albeit to a lesser extent.

While Mark Grammer, vice president of investment at Mackenzie Financial Corp. in Toronto, acknowledges that improved corporate governance and transparency are important considerations when investing in emerging markets, political risk cannot be ignored. In countries in which political risk is high, valuations are generally cheaper, representing a premium for taking on additional risk. That’s why systematic risk is considered a key determinant of return earned on a well-diversified portfolio.

For instance, Latin America is generally known for its high level of political risk. Power struggles in Brazil, Venezuela and Argentina in recent years have had major influence on investing decisions. On the other hand, Malaysia and Indonesia have had governments that have not kept their promises for reform, while investments in China have been clouded by concerns about leadership succession. The good thing is political risk is usually known and can be avoided.

However, broader risks in a given market are more difficult to avoid. The 1994-95 Mexican crisis, 1997 Asian crisis and 1998 Russian crisis are examples of negative national influence on market performance. The more recent 2001 Argentine crisis did not, however, cause a domino effect on emerging markets, partially because of the markets’ more solid infrastructures after the experiences of the 1990s.

Admittedly, investment decisions in emerging markets are complicated by varying accounting and financial reporting standards that make comparisons unreliable. Alternatively, in developed markets, there is a greater probability securities prices are a true representation of their underlying value.

However, Millar, Grammer and Wong all agree there have been significant improvements in legal, regulatory and financial reporting and, to a limited extent, the political infrastructure of emerging markets. Such developments have reduced investor risk.

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

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