INVESTING IN EMERGING EQUITY MARKETS

COLORADO PUBLIC EMPLOYEES RETIREMENT SYSTEMS FORUM May 8, 2007, Denver, Colorado

Professor Michael PalmerLeeds School of BusinessUniversity of Colorado at BoulderMichael.Palmer@colorado.edu

Goal of this Presentation

To offer some insights into the emerging market phenomenon, and To discuss some practical issues involved in constructing a globally diversified portfolio with emerging market equities.

Global Portfolios

Investors have long been aware of the potential benefits of adding foreign stocks to a portfolio.Basically, international diversification can reduce the risk and increase the return expected from a single market portfolio.The topic for us today is what are the issues in using the emerging markets for this purpose.

How Does Diversification Work?Global diversification works if equity markets in different countries don’t move together much.

So as long as economic, political, institutional, and psychological factors affecting security returns vary across countries, stock markets will show relatively low correlations.

But, what does the emerging market picture look like?

Correlation of Emerging Markets to US

First Practical IssueBad News: Overall, emerging markets are more closely related to the US market now than years ago.

This was to be expected as these emerging countries lifted their capital controls and became more integrated in the global economy.We can conclude then that achieving diversification benefits with emerging markets is more difficult today.

Good News: Correlations are not perfect; thus diversification benefits are still possible.

Next Issue. What About Returns?Long Run Returns:

From January 1988 to December 2006, emerging country stock markets have recorded an annualized return of 14.8% in US dollar terms.

Last Four Year Returns:For the four years ended December 31, 2006 emerging markets delivered an annualized return of 36.4% a year in US dollar terms.

Returns in 2006 and 2007In 2006 alone, the MSCI Emerging Markets Index rose 30%, led by an extraordinary 77% average gain in its four biggest countries — Brazil, Russia, India and China!In 2006, the Shanghai Composite Index posted a 128% gain, making it the “star performer” among equity markets.Thus far in 2007, the Shanghai Index continues to lead with a gain of 77%

How Do Emerging Market Returns Compare to Developed Markets?

Summary of ReturnsOver various periods of time, emerging markets as a group have delivered relatively high annualized returns.Many emerging markets have exhibited superior annual return performance relative to the US market.But what about the volatility (i.e., risk) of emerging market returns?

Comparison of Market Volatility

Standard deviation is a measure of an investment’s past volatility. The higher the standard deviation, the greater the volatility.

Emerging Markets Last 3 years

Last 5 years

Annual return 24.45% 21.46%

Standard deviation

17.71% 18.11%

S&P 500

Annual return 10.06% 6.95%

Standard deviation

6.27% 12.29%

Second Practical IssueGood News: Emerging markets have offered higher returns than the United States. Bad News: BUT, with greater volatility (i.e., greater risk).Potential Good News: Greater volatility means there is the potential on the upside for big returns.

Next Issue: So What are the Best (?) Models for Selecting Emerging Markets?

Studies show that for emerging markets, country performance is by far the biggest driver of equity returns — far exceeding sector and company performance. “In any given year, the worst stocks in the best-performing countries tend to outperform the best stocks in the worst performing countries.”So, we should focus on the COUNTRY when investing.

What Should We Focus On? Political Risk: Sudden changes in the political environment of the host country.

Thailand last year, Turkey last week.Globalization Risk: Changes in the overseas markets that a particular country is dependent on.

Who’s vulnerable to a slowdown in the US economy? Hong Kong, Singapore, Venezuela, Mexico, and Malaysia appear to be the most vulnerable as their exports to the United States make up more than 20 percent of their gross domestic product.

And More …

Inflation Risks: Equity investors do not like high and rising rates of inflation.

Examine each country’s inflation pressures.• Chile, Turkey, Russia today.

Interest Rate Risks: Equity investors do not like high and rising interest rates.

What is each country’s central bank doing.• Chile, Turkey, Brazil, and Russia today.

Third Practical IssueBad News: Unfortunately, the emerging markets comprise a very diverse set of countries with profoundly different political, economic, cultural, and regulatory regimes. This makes following them difficult.Good News: If you do get the country right, you probably don’t have to worry about companies and sectors.

Last Issue: Exchange Rates

Since you are based in the United States, you are ultimately concerned with the US dollar return on your emerging market investment.Question? Do exchange rates have an impact on your emerging market returns?Answer: Definitely, YES

Specific Emerging Market Examples in 2007 (Through 4/25)

Country Local Currency Return

U.S. Dollar Return

China 58.4% 60.2%

Brazil 11.7% 17.1%

India 3.1% 11.6%

Russia 0.2% 2.7%

Mexico 11.3% 10.2%

Venezuela -8.7% -9.6%

Fourth Practical IssueBad News: If the value of the foreign currency of the emerging market country declines against the US dollar, your return will be lower (Mexico and Venezuela in 2007).Good News: If the value of the foreign currency of the emerging market country increases against the US dollar, your return will be higher (the big 4 in 2007).Very Bad News: Forecasting exchange rates is almost impossible.

Fourth Practical IssueMore Good News: Some countries manage their currencies in relation to the dollar, so these currency rates are relatively stable (Hong Kong, Saudi Arabia, to some extent China).More Bad News: More and more countries are moving away from managing their currencies in relation to the US dollar.

China in 2005.

Where Do We Go From Here?Over the past decade, institutional investors -- pension funds, foundations, and endowments -- have increased their emerging market allocations. However by all measures, emerging markets are still underweighted in institutional portfolios.Question: Is expanded investment in emerging markets justified?Answer: Probably yes.

Final Word on Emerging MarketsIn the future, emerging market investments should continue to offer higher potential returns to investors but additionally with the potential for greater risk and greater volatility.And, while emerging markets are probably “in better shape than they’ve ever been,” the 8.8% plunge of China’s Shanghai Composite index on February 27th of this year, which dragged down emerging and developing markets alike, was a timely reminder of this risk and volatility.

APPENDIX 1:WHAT ARE EMERGING MARKETS?

Emerging Markets: What Are They?The term "emerging markets" was coined by the World Bank's International Finance Corporation in the early 1980s. Typically, emerging markets are in countries that:

are in the process of industrialization, andHave lower per capita gross national product (GNP) than the more developed countries.

Of the 130 countries that the international financial community generally considers to be emerging or developing countries, approximately 40 currently have stock markets.

APPENDIX 2: A LOOK AT GLOBAL DIVERSIFICATION

Do Security Returns Vary Across Country?

In the 1970s, when the investing world began to discover the benefits of global diversification, security returns showed little correlation.1973-1982 Data; US Stock Market to:

German Market: 0.170Japanese Market: 0.137United Kingdom Market: 0.279

Late 1980s and into the 1990sDuring this period, stock returns across markets started to show a greater relationship.

Driven by the globalization process.

First evidence: October 1987 global stock market crash when most developed markets declined together.1980-2000 correlation data of US markets to:

German market: 0.45 (0.170 for 1973-1982)Japanese market: 0.31 (0.137 for 1973- 1982)United Kingdom market: 0.58 (0.279 for 1973 - 1982)

What Does It Look Like Now?

APPENDIX 3:YEAR TO YEAR (IN)CONSISTENCY AMONG THE EMERGING MARKETS

Emerging Market ConsistencySTOCK EXCHANGE % Change 2005/2004

(in USD)

Egypt 146.4%

Columbia 126.3%

Saudi Arabia 113.2%

Russia 83.3%

Turkey 67.1%

Korea 62.3%

Pakistan 57.4%

Brazil 53.4%

Mexico 52.2%

India 42.0%

Emerging Market ConsistencySTOCK EXCHANGE % Change 2006/2005

(in USD)

China 138.4%

Venezuela 99.0%

Indonesia 73.1%

Russia 70.7%

Poland 61.4%

India 51.3%

Mexico 47.8%

Brazil 45.2%

Singapore 40.4%

South Africa 24.9%

Emerging Market ConsistencySTOCK EXCHANGE % Change 2007

(4/25) /2006 (in USD)

China 60.2%

Turkey 30.9%

Poland 24.1%

Malaysia 23.8%

Pakistan 21.6%

Brazil 17.7%

Czech Republic 16.6%

Chile 15.6%

South Africa 14.4%

Singapore 14.1%

APPENDIX 4:IMPACT OF EXCHANGE RATES ON US DOLLAR RETURNS

Exchange Rates Impact in 2006

Region 2006 Return in Local Currency

2006 Return inUS dollars

Americas 16.8% 17.0%

Asia-Pacific 24.6% 33.8%

Europe/Africa/Middle East

19.5% 27.1%

Average 19.1% 23.8%

Exchange Rates Impact in 2005

Region 2005 Return in Local Currency

2005 Return inUS dollars

Americas 7.6% 8.2%

Asia-Pacific 27.2% 18.3%

Europe/Africa/Middle East

23.6% 8.1%

Average 16.0% 10.0%

APPENDIX 5:THE CASE FOR EMERGING MARKETS

History of Emerging MarketsIn the late 1980s, emerging markets became the new frontier of global investing.In the early 1990s, these markets exhibited spectacular returns, only to be followed by an exceptionally long span of volatile and disappointing results. During the 1990s these markets moved from one crisis to the next:

the Mexican peso devaluation of 1994.the Asian financial crisis of 1997-1998, and the Russian ruble devaluation and debt default of 1998.Argentina debt crisis of 2000

The Case for Emerging Markets Today

1. Economic growth: Emerging markets are growing much faster than the developed countries in North America, Western Europe, and Asia. Over the ten-year period ended December 2005, emerging countries’ average annual growth rate was 5.5%, which was more than double the 2.7% growth recorded by developed countries during the same period.Economists expect this growth trend to continue for the foreseeable future.

The Case for Emerging Markets Today

2. Inflation has been on a downward trend in emerging markets for some time now.

Within this group. measured inflation has halved from the double digit numbers seen in the late 1990s.

Low inflation supports a continuation of high growth environment in the emerging countries. The IMF forecasts are for inflation to remain low.

The Case for Emerging Markets Today

3. Interest Rates: Interest rates in the emerging countries has trended down.The interest rate spread (which is a measure of risk) on emerging markets bonds has fallen significantly in the last five years from more than 1000 points to about 200 points today.The fall in rates and spreads is due primarily to low inflation and stable monetary policies.