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This document is directed at investment professionals and should not be distributed to, or relied upon by
retail investors. The value of investments, and the income from them, may fall or rise and investors may get
back less than they invested.
The role of emerging markets in diversified portfolios Peter Westaway Chief Economist and Head of Investment Strategy Group, Europe Vanguard
Citywire Wealth Management Retreat The Grove, October 2013
2
Market performance
• EM equities traditionally outperform DMs over the long run, but they can underperform for long periods
• Unwind of QE may harm EMs, but some fallback already priced in
Economic performance
• EM economies look set to continue to make a major contribution to world growth.....and within that, China will be very significant
• Prospects for EM economies look promising but risks abound (domestic and global issues, ie Fed policy, sovereign crisis, China slowdown)
Investment considerations for EMs
• Correlation between EM equity returns and EM growth is weak
• Contrary to popular belief, Ems are not a thin market where smart investors can make easy money
Key point: EM equities have an important role in diversified equity portfolios
Outline of presentation
3
Investor interest in EM surged since the financial crisis
Trailing 3-year flows in emerging equity products across the world
-30
-20
-10
0
10
20
30
40
50
60
70
1995 2000 2005 2010
Avera
ge a
nnual flow
over
36
-month
rolli
ng p
eriods
(US
D b
illio
ns)
Notes: Morningstar asset flows into US Open-end & EFT excluding Money Market funds, excluding Fund of Funds, Excluding Obsolete Funds and Diversified World Stock
Source: Vanguard, based on data from the Morningstar. Data as of 13 September 2013.
4
Source: Vanguard Investment Strategy Group based on MSCI. Data presented is as of 17 September 2013.
EM equities have typically outperformed DM... but with more volatility
Yearly percent change in total returns of developed and emerging market equities
-80%
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Year-
on-y
ear
gro
wth
Developed Markets Emerging Markets
5
EM equities have typically outperformed DM... but with more volatility
Difference in yearly percent change in total returns of DM and EM equities
-0.8
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: Vanguard Investment Strategy Group based on MSCI. Data presented is as of 17 September 2013.
6
EMs have outperformed DMs on average since 1990 but not systematically… recent performance has been lacklustre
Emerging markets - developed markets relative return (Jan 1990=100)
0
50
100
150
200
250
1990 1995 2000 2005 2010
Em
erg
ing M
ark
ets
-Develo
ped M
ark
ets
rela
tive
retu
rn (
Jan 1
990=
100)
Source: Vanguard Investment Strategy Group based on MSCI. Data presented is as of September 17, 2013. For additional details, see Vanguard white paper, Investing in emerging markets: Evaluating the allure of rapid economic growth, April 2010.
7
Emerging market valuations are now similar to those in developed market benchmarks
12-month trailing price to earnings ratio: Developed markets versus emerging
0
5
10
15
20
25
30
35
40
45
1995 1997 1999 2001 2003 2005 2007 2009 2011
MSCI Emerging Markets Index MSCI World Index
Emerging market valuations were not
as elevated as developed markets in
the early 2000's
Today, valuations
are more similar
Source: Vanguard Investment Strategy Group based on MSCI. Data presented is as of September 17, 2013. For additional details, see Vanguard white paper, Investing in emerging markets: Evaluating the allure of rapid economic growth, April 2010.
8
Risky bond segments (e.g. EM) had returned to pre-crisis yields …but recent Fed-related worries caused yields to rise again
0
5
10
15
20
25
2007 2008 2009 2010 2011 2012 2013
Yie
ld
Global Inv-Grade Corporates Global High Yield Corporates Emerging Market Debt
Source: Barclays as of 30 September 2013.
Notes: Global Investment Grade Corporates defined as the Barclays Global Aggregate Corporate Index, Global high Yield Corporates
defined as the Barclays Global High Yield Corporate Index, and Emerging Debt Defined as the Barclays EM USD Aggregate.
9
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1980 1985 1990 1995 2000 2005 2010 2015 Share
of
Glo
bal O
utp
ut
of
DM
and E
M e
conom
ies
Developed Markets Emerging Markets
EM economies are gradually taking a larger share of world GDP
Share of world GDP, 1980-2012, and forecast through 2018
Notes: Displays each region's share of global GDP, in nominal US dollar terms.
Source: Vanguard, based on data from the IMF April 2013 World Economic Outlook Database
10
The global economy is still relying on emerging markets to drive growth
Contribution to global real GDP growth, by market
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
1980s 1990s 2000s 2010-2013 Next 5 Years
Glo
bal R
eal G
DP
Gro
wth
U.S. Developed Markets (ex U.S.) Emerging Markets
Notes: Each region’s contribution to overall growth is defined as that region’s GDP weight at the beginning of
each time period multiplied by that region’s annual average growth rate over the time period measured.
Source: Vanguard calculations based on data from the IMF World Economic Outlook, April 2013.
11
...and within that, China’s contribution should continue to dwarf that of other EM regions
Contribution to Global Real GDP Growth, by market
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
1980s 1990s 2000s 2010-2013 Next 5 Years
Glo
bal R
eal G
DP
Gro
wth
China CEE ASEAN-5 LATAM
Source: Vanguard calculations based on data from the IMF World Economic Outlook, April 2013.
Notes: Each region’s contribution to overall growth is defined as that region’s GDP weight at the beginning
of each time period multiplied by that region’s annual average growth rate over the time period measured.
ASEAN-5 countries comprise Indonesia, Philippines, Malaysia, Singapore and Thailand.
12
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
1995 1997 1999 2001 2003 2005 2007 2009 2011
0%
20%
40%
60%
Chin
a
India
Austr
alia
Germ
any
Mexic
o
Canada
Russia
South
Kore
a
Japan
Fra
nce
Bra
zil
Spain
Italy
United S
tate
s
United K
ingdom
Regional developments: China – heading for a hard landing?
Economic growth appears to have bottomed... Yuan appreciating modestly
The recession forced some
rebalancing to occur, more
is needed
Nearly 50% vs. the 15-25% that
is typical of large economies
Investment share of GDP, 2012 China net exports, % of GDP
0.12
0.14
0.16
2003 2005 2007 2009 2011
US
D/Y
uan
0
2
4
6
8
10
12
14
2004 2006 2008 2010 2012
Real G
DP
Gro
wth
(
Year/
Year
%)
Sources: IMF, National Bureau of Statistics of China, People’s Bank of China, U.S. Federal Reserve and Vanguard Investment Strategy Group. Data as of 19 September 2013.
13
Regional developments: ASEAN-5 economies – susceptible to an external slowdown
Real GDP growth in ASEAN-5 Share of ASEAN-5 exports by destination
-6
-4
-2
0
2
4
6
8
2005 2007 2009 2011 2013 2015 2017
Real G
DP
gro
wth
15%
17%
19%
21%
23%
25%
27%
40%
45%
50%
55%
60%
65%
70%
75%
2005 2007 2009 2011 2013
Share
of
glo
bal export
s destined f
or
AS
EA
N-5
Share
of
glo
bal export
s destined f
or
develo
ped m
ark
ets
Advanced ASEAN-5 (RHS)
Source: IMF, World Economic Outlook, April 2013 and IMF Direction of Trade Statistics and Vanguard calculations. Data as of 19 September 2013.
ASEAN-5 countries comprise Indonesia, Philippines, Malaysia, Singapore and Thailand.
14
Regional developments: India – structural challenges weigh on growth prospects
Real GDP growth slowdown Investment slump has become a more generalised slowdown
Real GDP growth and IMF forecasts Real effective exchange rate
Source: IMF, World Economic Outlook, April 2013, Ministry of Statistics and Programme Implementation of India. Data as of 9 September 2013.
0
2
4
6
8
10
12
14
2005 2006 2007 2008 2009 2010 2011 2012 2013
Real G
DP
(y
ear-
on-y
ear
gro
wth
)
0
2
4
6
8
10
12
2006 2008 2010 2012 2014 2016 2018
Real G
DP
(y
ear-
on-y
ear
gro
wth
)
Actual WEO, April 2013 WEO, October 2012 WEO, April 2012 WEO, September 2011
-10
-5
0
5
10
15
20
25
30
2006 2007 2008 2009 2010 2011 2012 2013Q2
Year-
on-y
ear
gro
wth
Private Consumption Investment Exports
85
90
95
100
105
110
115
2006 2007 2008 2009 2010 2011 2012 2013
15
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
2004 2006 2008 2010 2012 2014 2016
Real G
DP
gro
wth
(y
ear-
on-y
ear
per
cent change)
Brazil Mexico Others
Regional developments: LATAM - capital inflows have likely been QE-fuelled
Real GDP growth Capital flows by country (USDbn)
-30
-20
-10
0
10
20
30
40
50
60
70
2007Q1 2008Q1 2009Q1 2010Q1 2011Q1 2012Q1 C
apital flow
s b
y countr
y (
bill
ions o
f dolla
rs)
Brazil Mexico Rest of LA5 LA5 total
Notes: Other- Chile, Colombia and Peru
Source: International Monetary Fund, World Economic Outlook April 2013.
16
Regional developments: Emerging Europe – Euro crisis has weighed on growth
Gradual recovery from 2012 slowdown Exports to Euro area (Q2 2008=100)
-8
-6
-4
-2
0
2
4
6
8
10
12
2004 2006 2008 2010 2012 2014
Real G
DP
gro
wth
(per
cent)
CEE excluding Poland and Turkey
Poland
Turkey
60
65
70
75
80
85
90
95
100
105
2008 2009 2010 2011 2012 E
xport
s to E
uro
are
a (
Q2 2
008=
100)
Around 50% of CEE
exports are destined
for the Euro area
Source: International Monetary Fund, World Economic Outlook April 2013. Data as of 9 September 2013.
17
• We find that the average cross-country correlation between long-run GDP growth and long-run stock returns has been effectively zero
Investing in emerging markets: Be wary of the allure of economic growth
18
Investing in emerging markets: Be wary of the allure of economic growth
Real GDP growth and real stock returns 1970–2012
Source: Vanguard, based on data from the IMF and FTSE. For details, see Vanguard paper, Investing in emerging markets: Evaluating the allure of rapid economic growth (Davis, et al., April 2010).
y = 0.05x + 0.05 R² = 0.00
-2%
0%
2%
4%
6%
8%
10%
12%
14%
0% 2% 4% 6% 8% 10% 12%
Avera
ge A
nnual R
eal E
quity M
ark
et R
etu
rn
Average Annual Real GDP Growth
19
• We find that the average cross-country correlation between long-run GDP growth and long-run stock returns has been effectively zero
Three factors explain this seemingly counterintuitive result:
– Economic growth surprises matter; expectations are priced in
– GDP growth may not be a good proxy for earnings growth in a world of multinational companies
– Much of the capitalization growth in emerging markets comes from share issuance rather than rising stock prices
Investing in emerging markets: Be wary of the allure of economic growth
20
Economic growth surprises matter; expectations are priced in
US economic growth surprises vs. equity market returns, 1970-2012
US consensus economic growth expectations vs. equity market returns, 1970-2012
R² = 0.2364
-60%
-40%
-20%
0%
20%
40%
60%
80%
-10% -5% 0% 5% 10%
1-Y
ear
Sto
ck M
ark
et R
etu
rn
Economic Growth Surprises
R² = 0.032
-60%
-40%
-20%
0%
20%
40%
60%
80%
-8% -3% 2% 7% 1-Y
ear
Sto
ck A
head M
ark
et R
etu
rn
Economic Growth Expectations
Source: Vanguard, based on data from the IMF, FTSE and Philadephia Fed's Survey of Professional Forecasters. Notes: Economic growth expectations are defined as the 1-year ahead median forecast from the Philadephia Fed's Survey of Professional Forecasters. Growth Surprises are then defined as the actual change, relative to that expectation. Equity market returns are defined as spliced total market index For details, see Vanguard paper, Investing in emerging markets: Evaluating the allure of rapid economic growth (Davis, et al., April 2010).
21
GDP is a poor proxy for equity market earnings
GDP growth versus earnings growth 1999-2012
4.4%
12.3%
5.2%
8.6%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
Developed Markets Emerging Markets
Avera
ge A
nnualiz
ed G
row
th
GDP Growth Earnings Growth
Source: Vanguard, based on data from the IMF and FTSE. For details, see Vanguard paper, Investing in emerging markets: Evaluating the allure of rapid economic growth (Davis, et al., April 2010).
22
Share issuance is a large component of growth in market capitalisation
Shares outstanding Components of market cap growth Jan 1995 - Dec 2012
7.4%
1.4%
5.3%
4.8%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
Emerging Markets Developed Markets A
nnualis
ed G
row
th
Share Growth Price Growth
75
100
125
150
175
200
225
250
275
300
325
350
375
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Jan.1
995 =
100
EM DM
Source: Vanguard, based on data from the IMF and FTSE. For details, see Vanguard paper, Investing in emerging markets: Evaluating the allure of rapid economic growth (Davis, et al., April 2010).
23
Often argued that EM is a thin market where active bets are more likely to pay off.
Theory and evidence suggest otherwise
Theory: The zero-sum game which holds in any market: before costs, for every investment that outperforms the index of a chosen market, there has to be another one that underperforms. But once costs are taken into account, it means that low-cost index funds will have a greater probability of outperforming higher cost actively managed funds.
Evidence: Our research suggests active managers no more likely to outperform in EM than in any other market.
Investing in emerging markets: Be wary of the argument that active management pays in EM
24
The theory of the zero-sum game
Below the market Above the market
Distribution of pre-cost returns
Benchmark return
Source: Vanguard
25
Importance of costs to the zero-sum game
Impact of costs
Average return after costs Average return before costs
Below the market Above the market
Source: Vanguard
26
0
5
10
15
20
25
30
35
40 Less than -
8%
-8 to -
7%
-7 to -
6%
-6 to -
5%
-5 to -
4%
-4 to -
3%
-3 to -
2%
-2 to -
1%
-1 to 0
%
0 to 1
%
1 to 2
%
2 to 3
%
3 to 4
%
4 to 5
%
5 to 6
%
6 to 7
%
7 to 8
%
More
than 8
%
Active Index
EM equity funds relative to MSCI EM Index
Dead funds:
Active 52
Index 0
Alive funds:
Active 130
Index 4
25% / 15% 75% / 85%
Outperforming / outperforming adjusted for survivorship bias
Source: Vanguard calculations, using data from Thompson Reuters Datastream and Morningstar, Inc.
Performance is over 5-years ending 31 December 2012. Past performance is no guarantee of future results.
27
Active managers underperform on average
Percentage of active equity managers underperforming their benchmark
Source: Vanguard calculations, using data from Morningstar, Inc.
Past performance is no guarantee of future results.
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
5 Years 10 Years 15 Years
EM
Survivors Only Corrected for Suvivor Bias
28
Debunking the market cycle myth
Percentage of EM equity funds underperforming prospectus benchmark
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Bull Market: Jan-1998 to Aug-2000
Bear Market: Sept-2000 to Feb-2003
Bull Market: Mar-2003 to Oct-2007
Bear Market: Nov-2007 to Feb-2009
Bull Market: Mar-2009 to Dec-2012
Source: Vanguard calculations, using data from Morningstar, Inc.
Past performance is no guarantee of future results.
29
• EM equities outperform DM over the long run, but long periods of underperformance too
• Unwind of QE may harm EMs, but some fallback already priced in
• EM economies look set to continue to make a major contribution to world growth.....and within that, China will be very significant
• Prospects for EM economies look promising but risks abound (domestic and global issues, ie Fed policy, sovereign crisis, China slowdown)
• Don’t assume that EM equity returns will correlate with EM growth; avoid making portfolio decisions based on their expectations for a particular country or region’s economic prospects
• It’s not any easier to make active bets in EM markets
• EM assets have an important role in diversified portfolios
Conclusions
30
The information contained in this presentation does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.
The information in this presentation does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this presentation when making any investment decisions.
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