Direct exposure to emerging market equities may not be the best way to capture the growth potential of those economies.
Instead, investors looking for the advantages of emerging market exposure should consider achieving it through holding companies based in developed economies that do business with emerging markets, according to a paper by Joon Woo Bae, an assistant professor at Case Western Reserve University’s Weatherhead School of Management, and Redouane Elkamhi and Mikhail Simutin, both associate professors of finance at the University of Toronto’s Rotman School of Management.
“To analyze the potential benefits of investing abroad, researchers often rely on foreign equity market indices where the constituent firms are publicly traded,” the paper said. “This approach can significantly understate potential diversification gains because publicly listed firms account for only a small share of the overall economy in many countries, especially in emerging markets.”
In many emerging markets, the economic activity represented by publicly listed stocks is relatively small, the paper noted. Meanwhile, while owning public equities listed in developed markets can provide exposure to emerging markets, it can also help gain exposure to areas of the emerging economies that wouldn’t be possible to access by simply buying their domestic stocks.
For example, it might be tricky for the average investor to get exposure to Indonesia’s major infrastructure growth. But they could gain exposure by investing in public Australian companies that export iron ore to Indonesia.
The researchers used a United Nations Comtrade database to isolate information on exports from specific industries heading from developed to emerging countries. They then created indexes of publicly traded companies based in developed markets, each isolating a particular industry. Each industry-specific index had high exposure to one emerging market and negligible exposure to others, in order to isolate the effectiveness of gaining exposure to a specific emerging market in this way. Developed markets with closer economic ties to the emerging market in question had higher weightings than others in the indexes.
Looking at another method, the researchers also created portfolios through mutual funds, multinationals and other investments available in multiple developed markets to create indexes meant to mimic the behaviour of emerging markets. Using this method as a benchmark, the researchers compared the mimicry indexes to their industry-specific indexes, seeking to differentiate the potential returns from the two methods. The mimicry indexes simply sought to replicate equity exposure to emerging markets, the paper said, whereas the industry-specific indexes were built to provide exposure to the emerging economy overall, rather than to the small slice represented by its domestic stocks.
The researchers found that this deeper exposure to an emerging economy can indeed be achieved using these industry-specific indexes, while mitigating the potential problems of direct exposure to emerging market securities.
“In particular, regression analysis shows that the performance of [these] portfolios is significantly associated with various proxies of emerging country economic activities, including growth in [gross domestic product], consumption, credit to private sector and industrial production,” the paper said. “We also confirm that the degree of exposure to the growth of economic activities in the emerging markets is stronger for [these] indices than it is for EM-mimicking portfolios.”