Emerging Market Returns Decomposed: Aiming to Mitigate Price Volatility, Amplify Return Contribution

 

OCTOBER 28, 2015 [EMERGING MARKETS, ACTIVE MANAGEMENT]
Charles Wilson, PhD


Managing the volatility and capitalizing on the long-term opportunity via fundamental company selection in emerging markets.

Recent returns from emerging market investments have been less than exciting. During times like this, it’s often helpful to step back and think about why we wanted to be involved in the first place. Everyone is aware that economic growth in emerging markets tends to be substantially faster than developed market growth (even now), driven by strong investment and rising income levels. What many may not appreciate is how well this has translated into market returns over time. Since inception in January 1988 through September 2015, the MSCI EM Index has generated an annualized total return of 10.6% in dollar terms. That’s very respectable. For comparison, during the same period, the S&P 500 Index delivered a 10.1% total return and the MSCI EAFE produced a 5.4% total return.

Possibly more surprising might be the split of contribution to the total return of the MSCI EM Index between three main factors: price, dividends, and currency. A simple way to decompose the return is to look at the performance of a currency basket weighted similarly to the MSCI EM Index (aka The MSCI EM Currency Index). Since inception of the MSCI EM Currency Index in January 1999 through the end of the third quarter of 2015, the MSCI EM Currency Index returned 111% relative to the U.S. dollar. During the same period, the MSCI EM Index had a total return of 305% and an equity price return (excluding dividends) of 164%. Ok great – so what? Well, these numbers indicate that you receive a little more than one-third of your return from currencies appreciating over time, most likely due to faster growth in these markets leading to positive net capital inflows. Second, dividends contribute just under half of the returns. What? EM dividends? Yes, EM companies tend to pay decent dividends because they know they are often competing for capital with fairly high-yield fixed income instruments such as sovereign bonds. For example, Brazilian sovereign bonds are currently yielding over 15%.

 

Long-term Annualized Total Returns of Major Benchmarks 1/1/1998 - 9/30/2015

Source: Morningstar

Past performance does not guarantee future results.

 

The remaining piece is the price return. It’s less than one-fifth of the overall return but is often responsible for the bulk of the volatility (often two-to-three times more volatility than the volatility of the currency contribution). Most of the volatility for a small portion of the return? Yes, that’s right – at least that’s what you get when you follow the index.

That’s where our active management focus comes in. We seek to identify the best businesses globally that can capitalize on the most exciting emerging market growth trends, regardless of where these firms are domiciled. We appraise the soundness of their business models, the quality of management, the attractiveness of their valuations, and the catalysts for their success. We believe high-quality, cash-flow generative businesses that compound earnings quickly can overcome day-to-day fluctuations in foreign exchange rates over time. Our focus on fundamental, bottom-up stock research has enabled us to construct lower volatility portfolios by avoiding pitfalls that may magnify it, such as leverage and hard-to-forecast macroeconomic risks. We think this is the right way to minimize the volatility in emerging markets while amplifying the many attractive aspects of investing in them.

Important Information
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Investments carry risks, including possible loss of principal. Additional risks may be associated with investments outside the United States, especially in emerging markets, including currency fluctuations, illiquidity, volatility, and political and economic risks. Investments in small- and mid-capitalization companies may increase the risk of greater price fluctuations. Investments in the Fund are not FDIC insured, nor are they bank deposits or guaranteed by a bank or any other entity.

The performance data quoted represents past performance; it does not guarantee future results.

The performance of any index is not indicative of the performance of any particular investment. Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. Investors may not make direct investments into any index.

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