Accessing emerging markets

For years, investors have been focused on emerging markets, starting with the BRICS (Brazil, Russia, India and China) and expanding to include other countries, such as Malaysia, Mexico, South Korea and Taiwan. The main argument for investing in emerging markets is access to sustained, above-trend economic growth that should translate into higher profits and therefore returns. These markets typically have a burgeoning middle class, increasing industrialization and urbanization, and a relatively young population. So the above-trend growth they offer has been coming from a number of areas, including infrastructure projects (roads, water treatment, housing) and higher spending on non-essential items such as consumer goods.

The big issue has always been how to access this above-trend growth. Commentary is often centred on emerging market equities, but there are many other ways to invest in emerging markets, including emerging market debt, infrastructure, private equity, real estate, agriculture and simply multinational companies with significant revenues derived from emerging markets.

For example, improving incomes in emerging countries have led to greater non-vegetable protein consumption, which in turn has led to increased crop production required to feed cattle. Thus, greater agricultural production is required, making agricultural crops and land more desirable. Often, investors will access these lands and crops in more developed nations such as the United States, Australia and Canada, but it’s clear production is intended to help feed the new middle class whose diets have changed.

As of Dec. 31, 2012, emerging market equities represented only 13% of the global market capitalization (in excess of $50 trillion), but 41% of global gross domestic product (estimated to be 48% by 2020). Corporate emerging market debt already exceeds $1 trillion, and this does not include debts issued by emerging market governments. Interestingly, more than 65% of emerging market debt issued is investment grade. As of Dec. 31, 2012, more than $115 billion was invested in “other” hedge funds in North America and Asia Pacific. Those regions saw more than $40 billion invested in “other” private equity, and more than $33 billion was invested in “other” real estate. While we don’t know the exact allocation to emerging markets (the survey simply provides the category “other”), some of this is most certainly investment in emerging markets alternatives.

In order to bring these numbers alive, here are two examples. The Canada Pension Plan Investment Board recently announced that it was buying a stake in a shopping centre REIT in Brazil, which is in addition to direct real estate that it already owns there. And two private equity firms, KKR and CDH Investments, have teamed up with China’s Modern Dairy Holdings to develop two 10,000 cow dairy farms over the next couple of years.

So how have investors fared? The MSCI Emerging Markets Index returned 6.58% on an annualized basis for the five years ending Sept. 30, 2013, while emerging market bonds earned almost 10% on an annualized basis over the same time period. While many of the countries in the emerging markets index continue to deliver above-average growth (measured against a global growth figure), including China, the prospect of rising U.S. interest rates, slowing growth and rising inflation in key emerging markets countries (Brazil and India) dampened enthusiasm and equity market returns.

Compare this to improving creditworthiness of many of the debts of emerging market countries and corporations, combined with declining interest rates. The HFRI Emerging Markets: Global Index trailed both long-only equity and debt, returning an annualized 4.45% as at Sept. 30, 2013. Emerging market private equity delivered returns between those of publicly traded equities and bonds, with a return of almost 7% for the five-year period ending Sept. 30, 2012 (the most up-to-date information available).

Over the same time period, the S&P 500 returned 9.35% on an annualized basis, and the MSCI World, 7.19%. While many companies are domestically focused, there are a number of multinational companies included in the MSCI World Index that derive more than 25% of their revenue from activities in the emerging markets (products and services).

While the next five years are unlikely to look like the prior five years, it’s clear that accessing the above-trend growth of emerging markets is no easy feat. Potential investors need to think about asset class allocation, risk and governance requirements, among other considerations.