emerging markets: opportunities and challenges in public equity investing

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  • Knowledge. Experience. Integrity.

    CALLAN INVESTMENTS INSTITUTE

    Research

    April 2016

    Emerging Markets

    Opportunities and Challenges in Public Equity Investing

    The last few years have been challenging for emerging market equities. In 2015, the MSCI Emerging

    Markets Index declined 14.9% and underperformed developed markets for the third straight year, dragged

    down by weak commodity prices, the slowing global economy, and the U.S. Fed interest rate hike in

    December. Looking ahead, Callans 2016 capital market projections forecast a 10-year outlook for emerg-

    ing market equities of 7.6% annualized return and a sizable 27.9% risk (standard deviation).

    We assembled a group of Callans experts to discuss this challenging yet exciting asset class, of which it

    might be said, When it was good, it was very, very good, and when it was bad it was horrid. Our experts

    included Ho Hwang, Andy Iseri, and Lyman Jung of our Global Manager Research group. (Their full biog-

    raphies can be found at the end of the paper.)

    Ho HwangVice President, Global Manager Research

    Andy Iseri, CFASenior Vice President, Global Manager Research

    Lyman JungVice President, Global Manager Research

  • 2

    Are emerging markets a safe place to invest? What are the associated risks?

    Andy Iseri Statistically,emergingmarkets(definedbyMSCI)experiencehighervolatilitythandevelopedmarkets,

    as seen in Exhibit 1. Coupled with relatively high correlation to other equity markets, an allocation to emerging markets typically leads to heightened volatility for the overall equity structure.

    Thereareothersignificantrisks,includingnaturalresourcepricedeclines,theslowdowninChina,cur-

    rencyrisk,risinginterestrates,andnon-financialrisks.(PleaseseeSection1:DetailedDiscussionof

    Emerging Market Risks in the Appendix for a deeper dive into these various risks.) However, emerging

    marketequitiesstillplayanimportantroleinwell-diversifiedinstitutionalportfolios.

    Sources: MSCI, Callan PEP

    2015 Emerging Markets Performance CommentaryIn 2015, the appreciation of the U.S. dollar materially impacted performance on the U.S. dollar-de-

    nominated MSCI Emerging Markets Index. Many currencies declined by double digits on a percent-

    age basis against the U.S. dollar amid global growth concerns. The local currency version for the

    MSCI Emerging Markets Index was down 5.8% in 2015 (compared to -14.6% for the U.S. dollar

    version), so currency alone cost the Index nearly 900 basis points. All sectors declined in the asset

    class, led by Materials (-21.6%), Utilities (-20.8%), and Telecom (-19.6%). The best performing sec-

    tor was Health Care at a dismal -5.2%. From a style and market cap perspective, growth outper-

    formed value stocks by more than 700 basis points, and small cap bettered mid/large cap stocks by

    800 basis points for the year.Lyman Jung

    0%

    10%

    20%

    30%

    40%

    13.2 MSCI Emerging Market

    9.7 MSCI World

    91 07 08 09 10 11 12 13 14 15989796959493 9992 06050403020100

    Exhibit 1

    Rolling 12 Quarter

    Standard Deviation

    for 25 Years ended

    December 31, 2015

  • 3Knowledge. Experience. Integrity.

    China Fell 8% as the central governments pursuit of the anti-corruption

    campaign continued TheCentralBankcuttheinterestratefivetimesandannounceda

    surprise devaluation of the renminbi

    Hungary Best-performing emerging market (+36%); boosted by Prime

    Minister Victor Orbans economic reforms Improving economic prospects and a potential return to invest-

    ment grade debt rating helped gains

    Russia Among the few bright spots, Russia was one of only two emerging

    market countries that was positive, up 4% for the year The ruble fell 20% against the U.S. dollar, so the rally was much

    less impressive in U.S. currency Russian stocks rebounded after steep losses in 2014, helped by

    thecentralbankcuttingtheinterestratefivetimesin2015

    Indonesia Declined by more than 19% as growth slowed despite the govern-

    ments economic stimulus plan Rupiah fell 10% against the U.S. dollar

    Brazil Equities were down more than 41% as the economy plunged into

    recession Hamperedbyhighinflation,highunemployment,lowcommodity

    prices, and political uncertainty amid continued fallout from the Petrobras investigation

    Turkey Down32%despitebenefitingfromloweroilprices Lira fell 20% against the U.S. dollar

    2015 Emerging Market Highlights

    Greece Worst-performing emerging market (-61%) as the countrys debt

    crisis continued Its potential withdrawal from the euro zone and continued auster-

    ity measures hampered returns

    India Fell 6% in dollar terms as the excitement over reforms and eco-

    nomic improvements waned over the year Currency was also a headwind as it fell 5% against the U.S. dollar

  • 4

    Callan Periodic Table of Investment Returns: Emerging Markets

    Are we truly tapping into emerging market growth by investing in indices? What are your thoughts on alternative emerging market products?

    Ho Hwang Investments in emerging markets continue to enable investors to capitalize on the growing economies

    within developing markets. According to MSCI economic exposure data, the MSCI Emerging Markets

    Index has consistently derived approximately 80% of its revenues from emerging markets over the past

    fiveyears.(SeeSectionII:ADeeperDiveIntotheMSCIEmergingMarketsIndexintheAppendix for

    a detailed discussion of this Index.) Two breeds of products centered on emerging market consumption

    areslowlybubblingup:directandindirectemergingmarketconsumerstrategies.Althoughbothproducts

    seek to capture the burgeoning emerging market middle class and focus on consumer-related sectors,

    they have differentiated investable universes.

    Sources: Callan, The FTSE Group, MSCI, Russell

    2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

    FTSE Emerging

    SC

    34.8%

    FTSE Emerging

    SC

    53.8%

    Russell 3000

    -37.3%

    FTSE Emerging

    SC

    117.2%

    Russell Emerging Mkts SC

    28.1%

    Russell 3000

    1.0%

    FTSE Emerging

    SC

    25.2%

    Russell 3000

    33.6%

    Russell 3000

    12.6%

    Russell 3000

    0.5%

    Callan Emerging Mkt Style

    34.3%

    Russell Emerging Mkts SC

    43.9%

    MSCI World ex US

    -43.6%

    MSCI Emerging Mkts SC

    113.8%

    MSCI Emerging Mkts SC

    27.2%

    MSCI World ex US

    -12.2%

    Russell Emerging Mkts SC

    24.2%

    MSCI World ex US

    21.0%

    FTSE Emerging

    1.6%

    MSCI World ex US

    -3.0%

    Russell Emerging Mkts SC

    33.7%

    MSCI Emerging Mkts SC

    42.0%

    FTSE Emerging

    -52.9%

    Russell Emerging Mkts SC

    96.6%

    FTSE Emerging

    SC

    25.8%

    MSCI Emerging Markets

    -18.4%

    MSCI Emerging Mkts SC

    22.2%

    Russell Emerging Mkts SC

    5.3%

    FTSE Emerging

    SC

    1.5%

    MSCI Emerging Mkts SC

    -6.8%

    Russell Emerging Markets

    33.4%

    Russell Emerging Markets

    40.9%

    Callan Emerging Mkt Style

    -53.3%

    Russell Emerging Markets

    83.8%

    Russell Emerging Markets

    21.7%

    Callan Emerging Mkt Style

    -18.5%

    Callan Emerging Mkt Style

    19.6%

    FTSE Emerging

    SC

    2.3%

    MSCI Emerging Mkts SC

    1.0%

    Russell Emerging Mkts SC

    -8.9%

    FTSE Emerging

    33.1%

    MSCI Emerging Mkts IMI

    39.8%

    MSCI Emerging Markets

    -53.3%

    FTSE Emerging

    82.6%

    MSCI Emerging Mkts IMI

    19.9%

    FTSE Emerging

    -19.0%

    Russell Emerging Markets

    18.8%

    MSCI Emerging Mkts SC

    1.0%

    Russell Emerging Mkts SC

    -0.3%

    FTSE Emerging

    SC

    -10.5%

    MSCI Emerging Mkts SC

    33.0%

    FTSE Emerging

    39.7%

    MSCI Emerging Mkts IMI

    -53.8%

    MSCI Emerging Mkts IMI

    82.4%

    FTSE Emerging

    19.8%

    Russell Emerging Markets

    -19.4%

    MSCI Emerging Mkts IMI

    18.7%

    Callan Emerging Mkt Style

    34.3%

    Callan Emerging Mkt Style

    -1.1%

    Russell Emerging Markets

    -12.8%

    MSCI Emerging Markets

    32.2%

    MSCI Emerging Markets

    39.4%

    Russell Emerging Markets

    -55.5%

    MSCI Emerging Markets

    78.5%

    Callan Emerging Mkt Style

    19.4%

    MSCI Emerging Mkts IMI

    -19.5%

    MSCI Emerging Markets

    18.2%

    Russell Emerging Markets

    0.0%

    Russell Emerging Markets

    -1.7%

    Callan Emerging Mkt Style

    -13.7%

    MSCI Emerging Mkts IMI

    31.7%

    Callan Emerging Mkt Style

    39.1%

    MSCI Emerging Mkts SC

    -58.2%

    Callan Emerging Mkt Style

    77.3%

    MSCI Emerging Markets

    18.9%

    Russell Emerging Mkts SC

    -25.3%

    FTSE Emerging

    17.9%

    MSCI Emerging Mkts IMI

    -2.2%

    MSCI Emerging Mkts IMI

    -1.8%

    MSCI Emerging Mkts IMI

    -13.9%

    MSCI World ex US

    25.7%

    MSCI World ex US

    12.4%

    Russell Emerging Mkts SC

    -59.5%

    MSCI World ex US

    33.7%

    Russell 3000

    16.9%

    FTSE Emerging

    SC

    -27.1%

    Russell 3000

    16.4%

    MSCI Emerging Markets

    -2.6%

    MSCI Emerging Markets

    -2.2%

    MSCI Emerging Markets

    -14.9%

    Russell 3000

    15.7%

    Russell 3000

    5.1%

    FTSE Emerging

    SC

    -63.3%

    Russell 3000

    28.3%

    MSCI World ex US

    8.9%

    MSCI Emerging Mkts SC

    -27.2%

    MSCI World ex US

    16.4%

    FTSE Emerging

    3.5%

    MSCI World ex US

    -4.3%

    FTSE Emerging

    -15.2%

    See page 15 in the

    Appendix for the standard

    Callan Periodic Table

    of Investment Returns,

    which may provide useful

    additional context.

  • 5Knowledge. Experience. Integrity.

    The direct products gravitate to emerging market small cap companies, while the indirect strategies veer to

    multi-national, developed market, large cap companies. Both direct and indirect strategies have performed

    well (albeit having short track records) and offer beta around 0.80 relative to the MSCI Emerging Markets

    Index.Despitethefavorablerisk/returnprofile,theseproductsmaypotentiallyhaveoverlapriskwithother

    asset classes given their investable universe and subsequently disrupt the non-U.S. equity structure. As

    such, both direct and indirect products may not be ideal for a core allocation, but viable for an opportunistic

    mandate.

    What about frontier markets?

    Ho Hwang Frontier marketscountries with investable stock markets that are less established than those in the

    emerging marketsare directly tied to their local economies. They are not a viable option to get indirect

    exposure to emerging markets, considering only about 7% of revenues (MSCI Frontier Markets Index)

    stem from emerging markets. (See Exhibit 11 in the Appendix.) Frontier markets offer a unique risk/

    returnprofileduetotheirlowcorrelationtoothernon-U.S.equities.

    Therearetwotypesoffrontiermarketstrategies:pureandhybridproducts.Similartodirectandindirect

    emerging market products, pure and hybrid frontier market strategies are differentiated by the investable

    universe. The pure products solely focus on frontier markets, whereas the hybrid portfolios utilize both

    emerging and frontier markets. Because the hybrid products also invest in emerging markets, they may be

    anoptionforinvestorsseekingemergingmarketexposurewithfrontiermarketflexibility.

    What are some of the non-financial reasons to invest in emerging markets?

    Andy Iseri Weoftendiscuss theeconomicandfinancial rationales foremergingmarket investing.But thereare

    somenon-financialconsiderationswheninvestinginemergingmarkets,andperhapsforemostamong

    these is the demographical shift taking place in these markets.

    The vast majority of the worlds population live in emerging and frontier markets. The world has approxi-

    matelysevenbillionhumans:Chinaspopulationtotalsmorethan1.3billion,Indiasisover1.2billion,and

    the U.S. has a mere 300 million. If an investor wants exposure to consumers, emerging markets should be

    their focus. Not only is the current population tilted to emerging economies, so too is the trend of population

    growth. Exhibit 2 shows past and projected population statistics for select countries and regions.

    Sources: Richard Hokenson, United Nations

    0

    200

    400

    600

    800

    1,000

    1,200

    1,400

    1,600

    1,800

    2,000

    50 30 35 40 45 50858075706560 9055 25201510050095

    Pop

    ulat

    ion

    (mill

    ion)

    Brazil China Europe India Russia U.S.

    Present day (2016)

    Exhibit 2

    Past and Projected

    Population Statistics

  • 6

    This chart depicts the population of least, less and more developed economies by age bracket. As

    time marches on and people age, areas with downward-sloping bars will see increases in working-age

    populations.

    Perhaps more important than total population is the working-age population. Many developed countries

    face aging populations. A shrinking workforce relative to a growing retired population spells trouble.

    Strong future economic growth requires a growing workforce, and trends favor emerging markets. As

    time marches on, populations in these economies are not only larger, but younger. These less-devel-

    oped economies will have ample working-aged people for years to come. People in more developed

    countries do live longeralthough that poses a different set of issues for pension plans.

    Is a diversified global emerging market strategy better than local specialists?

    Ho Hwang Although country/regional specialists provide local expertise, global emerging market strategies in gen-

    eralhavethefollowingdistinctiveadvantages:cost,regionalallocation,cross-countrystockselection,

    and risk management. Unlike global emerging market strategies, a structure with local specialists can

    be expensive as it requires multiple managers (i.e., Asia, Europe and Middle East, and Latin America)

    to gain full emerging market exposure. Further, these local strategies may also have higher vetting and

    monitoring costs considering their regional locations. Additionally, a structure with regional managers

    underutilizes alpha opportunities from country and regional allocations.

    Country and regional performance dispersion is wide within emerging markets (Exhibit 4).Thefive-yearreturn difference between the best-performing country (United Arab Emirates) and the worst-performing

    country (Greece) was 46%. Regionally, emerging Asia beat emerging Latin America by roughly 13%.

    Global emerging market strategies are better positioned to capture this performance gap relative to local

    specialists because regional allocation, stock selection, and risk management processes are holistically

    managed to construct optimal portfolios. Conversely, with regional strategies asset owners would be

    Exhibit 3

    Population of Least,

    Less, and More

    Developed Economies

    by Age

    Least Developed Less Developed More DevelopedP

    opul

    atio

    n (m

    illio

    n)

    0

    100

    200

    300

    400

    500

    600

    04 100+9599909485898084757970746569606455595054454940443539303425292024159101459

    Age brackets

    Source: World Economic Forum

  • 7Knowledge. Experience. Integrity.

    responsible for top-down decisions and execution. To simplify this process, plans may adopt a static

    regional allocation. Unfortunately, such a structure would mute alpha opportunity and quite possibly

    heighten risk given the country/regional performance dispersion. Moreover, company valuation and risk

    assessment across countries and regions are limited with local specialists due to their narrow universe,

    which may lead to sub-optimal stock selection and unintended risk exposure. Although we recognize that

    country or regional specialists have local insights, top-down considerations have the potential to derail

    stock selection.

    EM Latin America

    -11.4%

    -4.8%-0.8%

    -14.4%

    All EmergingMarkets

    EM Europe and Middle East EM Asia

    Exhibit 4

    Five-Year Regional

    Performance

    (U.S. Dollars)

    Sources: Callan, MSCI

    Five-Year Country

    PerformanceGreece

    Brazil

    Colombia

    Chile

    Peru

    Russia

    Turkey

    Poland

    Czech Republic

    South Africa

    Hungary

    All Emerging Markets

    Egypt

    Indonesia

    Malaysia

    Mexico

    India

    Korea

    Taiwan

    Thailand

    China

    Qatar

    Philippines

    United Arab Emirates

    -33%

    13%

    11%

    5%

    1%

    0%

    -20%

    -14%

    -14%

    -13%

    -12%

    -9%

    -9%

    -8%

    -6%

    -5%

    -5%

    -4%

    -3%

    -3%

    -2%

    -2%

    -2%

    -1%

    Sources: Callan, MSCI

  • 8

    How do you construct an emerging market structure?

    Lyman Jung Aswithmostassetclasses,Callanadvocates forabalanceddiversifiedapproachwhenconstructing

    an emerging market structure. We believe it is sub-optimal for an overall structure to be exposed to

    significantbiasesrelativetotheassumptionsusedinassetallocationstudiesunlessthosebiasesare

    intended and supported by sound investment principles. Many factors should be considered, including

    overall and component style factors, market capitalization, and sector, country, and currency exposures.

    Factors can have different levels of importance in emerging markets relative to developed. For example,

    the impact of style (value/growth) is generally less pronounced in emerging markets than in developed

    markets or single-country strategies. Country exposure has a heightened effect relative to developed

    markets.

    Callan also pays close attention to return patterns and performance predictability. For example, an

    emerging market manager with a quality growth philosophy may display strong growth characteristics;

    however, the managers performance pattern exhibits downside protection and as such may be appro-

    priate as a standalone manager. Managers in a multi-emerging markets structure should complement

    each other as far as style, fundamental vs. quantitative investment processes, and top-down vs. bottom-

    up managers, while close attention is paid to their return patterns.

    Country or regional specialists can also be utilized, as they may offer specialized local research into

    less-covered areas. In this case, plan sponsors would have to manage the allocations to each special-

    ist while individual managers would focus on stock selection since they lack the ability for cross-border

    investing. Use of specialists will lead to an increased number of managers.

    Passive implementation may have a place in the overall non-U.S. equity structureperhaps in a core/

    satellite approach where the passive sleeve is the structures anchor and the satellite manager may be

    a high active share, high tracking error, conviction-driven manager where risk can be afforded. Callan

    advocatesforactivemanagementinlessefficientassetclassessuchasemergingmarkets.Historyhas

    shown that active management over longer time periods generally outperforms the MSCI Emerging

    Markets Index and adds value (Exhibit 5). A batting average of rolling three-year outperformance when considering various fee hurdles is shown in the Appendix, Exhibit 12.

    Exhibit 5

    Rolling 12-Quarter

    Excess Return

    relative to MSCI

    Emerging Markets

    20 Years ended

    December 31, 2015

    Source: Callan

    -10%

    0%

    10%

    20%

    07 08 09 10 11 12 13 14 15989796 99 06050403020100

    Callan Emerging Markets Style (10th90th percentile) Median

  • 9Knowledge. Experience. Integrity.

    Is environmental, social, and governance (ESG) investing appropriate for emerging markets?

    Andy Iseri Our current approach to ESG investing, which is similar to how we approach all aspects of investing,

    is to gather information, conduct research, gain broad knowledge, and assist our clients in making an

    informed decision that is right for them.

    ESG investing in emerging markets offers risks and opportunities. There is opportunity that emerging

    countries leap-frog togreener,moreenergy-efficienteconomies.Therearealso risks thatdataand

    corporatefilingsare less robustand less reliablegiven less-developed (albeit improving)accounting

    and reporting standards.

    Emerging markets represent approximately 10% of the global investment universe for public equity. Is this a reasonable allocation?

    Ho Hwang A strategic 10% weight to emerging markets within a public equity allocation is reasonable, considering

    suchexposurewouldbeinlinewithitsmarketcapitalizationinthepublicequityuniverse(definedbythe

    MSCI ACWI IMI). Historical emerging market exposure for the global universe is shown in the Appendix,

    Exhibit 13. Although Callans 10-year return forecasts point to higher returns from emerging markets

    relative to other equity asset classes, they are accompanied by higher risk (volatility), which can lead to a

    less-favorablerisk/returnprofile.Despitesucharisk/returnprofile,thecurrentvaluationspreadbetween

    developed and emerging markets may create an opportunity for a tactical emerging market overweight.

    Investors should also take note of the assumptions used in their asset-allocation and asset-liability stud-

    ies. Any deviation from these assumptions would constitute assumption risks.

    For Further Reading

    To learn more about emerging markets and related topics, see the following research on Callans website:

    ThePeriodicTableCollection:RankingsofAssortedIndicesandStrategies

    2016 Capital Market Projections

    Global Equity Benchmark Review

    Going Global? (charticle)

    https://www.callan.com/research/files/1209.pdfhttps://www.callan.com/research/files/1211.pdfhttps://www.callan.com/research/files/1210.pdfhttps://www.callan.com/research/files/702.pdf

  • 10

    AppendixSection 1: Detailed Discussion of Emerging Market (EM) Risks

    Natural Resources: Investors face daily headlines about the price of oil and other commodities. Dramatic price declines have put a strain on many resource-producing countries. Several EM governments rely on

    oil revenue to fund their budgets. This can affect entire societies as funding for social programs becomes

    challenged. Notable resource-producing EM countries include Russia, United Arab Emirates, Brazil, and

    Mexico. EM oil producers include Saudi Arabia, Iran, Iraq, and Kuwait. Lower for longer is a threat to both

    economicandsocialstability,aswellastocorporateprofits, forproducers.Theoil/commodityenviron-

    ment isnotbadforallcountries.Countriesthatareconsumersoftheseresourcesdirectlybenefitfrom

    lower prices. Emerging and frontier countries topping this list include China, India, South Korea, Taiwan,

    Thailand, and Poland. The natural resources environment is an area of both risks and opportunities.

    China Slowdown: Another story topping the news is the slowdown in China. China was considered the driver of global economic growth until 2011. Since then, Chinas year-on-year GDP growth (Exhibit 6) fell from 12% to estimates of about half of that. This slowdown has broadly affected commodity producers

    and exporters to China. Chinas slowdown coincides with an economic shift from focusing on manufactur-

    ing to services and consumers. Along with corruption and market reforms, the eventual outcome of these

    dynamic forces is uncertain.

    -5%

    0%

    5%

    10%

    15%

    1980 2010 2015199519901985 20052000

    GD

    P G

    row

    th

    U.S. Growth China GrowthExhibit 6:

    GDP Growth

    U.S. and China

    Sources: Callan, statisticstimes.com

  • 11Knowledge. Experience. Integrity.

    Currency: Non-U.S. exposure for U.S.-based investors includes the investment security and the currency it is denominated in. Simply put, if a currency goes up (U.S. dollar weakness or foreign currency strength)

    it helps returns, if a currency goes down (U.S. dollar strength or foreign currency weakness) it detracts.

    Currency risk from emerging market exposure has been heightened by the recent rise in the U.S. dollar.

    As central banks around the globe balance their mandates for economic stability, employment, and com-

    petitiveness, currency volatility has increased to the detriment of U.S. dollar-based investors. Exhibit 7 shows the relative performance of MSCI EM Local Currency to the standard U.S. dollar-denominated index

    to highlight the currency effect to U.S. dollar-based investors. Currency effect has been generally nega-

    tive since 2011. The question facing investors is whether the dollars upswing is largely doneor if theres

    more to come.

    Rising U.S. Interest Rates: Conventional wisdom says that the U.S. Federal Reserve is in a tightening phase. Strong economic growth relative to the rest of the world has most investors expecting a contin-

    ued path to higher interest rates in the U.S. For emerging countries this poses two problems. First, as

    globalassetsseekhigher-yieldinglow-riskassets,capitalflowstotheU.S.fromothercountriesincluding

    emergingmarkets.Manyemergingeconomiesrelyonforeigninvestmenttofundgrowthcapitaloutflows

    from those countries risks the slowing of investment. A second risk to emerging markets from higher U.S.

    interest rates concerns external debt. Many governments, corporations, and banks in emerging markets

    tookadvantageoflow-costU.S.dollar-denominatedfinancing.Itisestimatedthatover$4trillioninU.S.

    dollar-denominated debt exists in emerging markets. As U.S. interest rates rise, capital leaves, and emerg-

    ing currencies devalue, servicing this debt could be problematic. Countries facing the highest external debt

    challenges include Brazil, Turkey, and South Africa.

    Non-Financial Risks: The sources of risk when investing in any country are too numerous to list, but investors should consider things like shareholder rights, rule of law, corruption, etc. Some key risks and

    country ratings for 2015 are shown in Exhibit 8.

    -13.4%

    3.2%

    2006

    -6.2%

    1.4%

    -5.5%

    4.9%

    20142013201220112010200920082007 2015

    10.3%

    4.5%

    -6.6%

    -9.4%

    Sources: Callan, MSCI

    Exhibit 7

    Calendar Year Relative Returns of MSCI EM (unhedged) to MSCI EM Local Currency

  • 12

    Source: World Economic Forum

    Judicial independence

    1-7 (best)

    Property rights

    1-7

    Favoritism in decisions of government

    officials 1-7

    Organized crime

    1-7

    Strength of auditing and

    reporting standards

    1-7

    Soundness of banks

    1-7

    Regulation of securities exchanges

    1-7

    Protection of minority

    shareholders interests

    1-7

    Strength of investor protection 010 (best)

    Brazil 3.6 4.0 2.6 3.9 5.2 6.1 5.4 4.7 5.3

    Chile 5.2 5.0 4.0 5.5 5.2 6.3 5.3 4.6 6.3

    China 4.0 4.5 4.1 4.7 4.4 5.0 4.4 4.1 5.0

    Colombia 2.8 3.9 2.6 2.8 4.5 5.8 4.0 4.1 8.3

    Czech Republic 3.9 4.0 2.6 5.0 4.9 5.9 4.4 4.1 5.0

    Egypt 4.0 3.6 3.7 3.5 3.8 4.2 3.5 3.5 3.7

    Greece 3.7 3.9 2.6 5.5 4.3 2.8 3.7 4.3 5.3

    Hungary 4.0 3.7 2.4 4.9 5.2 4.8 4.4 4.1 4.3

    India 4.2 4.1 3.4 4.0 4.2 4.3 4.3 4.1 6.3

    Indonesia 3.9 4.3 3.9 4.2 4.6 5.1 4.5 4.6 6.0

    Malaysia 4.9 5.3 4.5 5.2 5.7 5.7 5.5 5.3 8.7

    Mexico 3.2 4.0 2.7 2.7 5.0 5.6 4.8 4.3 5.7

    Morocco 3.5 4.9 3.5 5.7 5.0 5.6 4.5 4.3 4.7

    Pakistan 3.8 3.3 2.6 3.0 4.3 4.8 4.5 4.0 6.3

    Peru 2.5 3.5 2.7 3.1 5.0 5.8 4.8 4.3 7.0

    Philippines 3.6 4.3 3.1 4.7 5.1 5.5 4.6 4.5 4.3

    Poland 4.1 4.3 3.1 5.6 4.9 5.4 4.9 4.0 6.0

    Qatar 6.0 6.0 5.6 6.7 6.0 6.3 5.9 6.0 4.3

    Russia 2.9 3.3 2.8 4.2 4.1 4.0 3.7 3.5 4.7

    South Africa 5.4 5.6 2.6 4.3 6.7 6.5 6.4 6.1 8.0

    South Korea 3.5 4.2 2.9 4.3 4.4 3.9 3.7 3.4 6.0

    Taiwan 4.2 5.7 4.1 5.8 5.7 5.7 5.4 5.1 6.3

    Thailand 3.8 4.1 2.8 4.5 5.1 5.7 5.0 4.9 7.7

    Turkey 3.1 4.6 3.2 4.4 4.8 5.7 4.6 4.3 6.3

    UAE 5.6 5.5 5.3 6.8 5.5 5.9 5.5 5.3 5.0

    Exhibit 8: Key Risks by Country

  • 13Knowledge. Experience. Integrity.

    Section 2: A Deeper Dive Into the MSCI Indices

    Thesignificanceofcountryofdomicileforcompaniesisdiminishingduetoglobalization.Assuch,MSCI

    has developed a methodology to calculate the economic exposure of the underlying constituent companies

    by segregating their revenues based on geographic distribution. The following exhibits provide the regional

    economic exposure for the various indices. The economic exposure for the MSCI Emerging Markets Index

    hasbeenconsistentoverthepastfiveyears(Exhibit 9). In 2010, 81% of the Index was economically tied to emerging markets, which declined only by 2% in 2015 to 79%. As the engine of growth in emerg-

    ing markets, China is the biggest revenue contributor with 37% in 2015, which increased by 13% from

    24% in 2010. Interestingly, the Emerging Markets Small Cap Index (Exhibit 10) has a similar economic exposureprofile,with83%ofrevenuescomingfromemergingmarkets.Theeconomicexposureforthe

    MSCI Frontier Markets Index (Exhibit 11) hasevolvedoverthepastfiveyears.In2010,58%ofrevenuewas driven by frontier markets. In 2015, it jumped to 80%, suggesting some economic convergence within

    frontier markets.

    7.2%

    Developed Markets

    57.9%

    80.3%

    9.7%12.0%

    Frontier MarketsEmerging Markets Other Countries

    20.4% 6.9% 5.6%

    80.9% 79.6%

    2010 2015

    17.6%

    Developed Markets

    1.4% 1.5% 2.3%15.4%

    Frontier MarketsEmerging Markets Other Countries

    80.9% 78.9%

    2.0%

    13.6%

    Developed Markets

    1.2% 1.3% 2.0%15.6%

    Frontier MarketsEmerging Markets Other Countries

    81.1% 83.2%

    2.0%

    Exhibit 11

    Economic Exposure for the MSCI Frontier Markets Index

    Exhibit 9

    Economic Exposure for the MSCI Emerging Markets Index

    Exhibit 10

    Economic Exposure for the MSCI Emerging Markets Small Cap Index

    Sources: Callan, MSCI

  • 14

    0%

    4%

    8%

    12%

    16%

    20152006 2010200920082007 2014201320122011

    11.0% 10-Year Average Emerging Market Exposure

    Sources: Callan, MSCI

    Exhibit 13

    Emerging Markets

    Exposure within

    MSCI ACWI IMI

    for 10 Years ended

    December 31, 2015

    Section 3: Other Exhibits

    Fee Hurdle 0.70% 0.75% 0.80% 0.85% 0.90% 0.95% 1.00% 1.05% 1.10% 1.15%Median 65% 65% 63% 63% 61% 58% 56% 56% 56% 51%

    45th Percentile 74% 71% 71% 71% 70% 69% 69% 68% 68% 65%

    40th Percentile 81% 81% 80% 79% 79% 76% 76% 74% 74% 73%

    35th Percentile 91% 91% 90% 90% 88% 86% 84% 84% 84% 84%

    30th Percentile 99% 99% 99% 98% 96% 96% 96% 96% 95% 94%

    25th Percentile 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

    AverageAnnualizedExcessReturnMedianManager:1.45%

    Exhibit 12

    Batting Average of

    3-Year Periods Where

    Peer Group Median

    Manager Beats the

    Benchmark by More

    than Typical Fee Hurdles

    The median manager in Callan Emerging Markets Broad peer group had an average annualized excess

    return of 1.45%.

    Source: Callan

  • 15Knowledge. Experience. Integrity.

    Sources: Barclays, MSCI, Russell, Standard & Poors

    2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

    MSCI Emerging Markets

    32.6%

    MSCI Emerging Markets

    39.8%

    Barclays Aggregate

    5.2%

    MSCI Emerging Markets

    79.0%

    Russell 2000

    Growth

    29.1%

    Barclays Aggregate

    7.8%

    MSCI Emerging Markets

    18.6%

    Russell 2000

    Growth

    43.3%

    S&P 500 Growth

    14.9%

    S&P 500 Growth

    5.5%

    MSCI EAFE

    26.3%

    MSCI EAFE

    11.2%

    Barclays Corp High

    Yield

    -26.2%

    Barclays Corp High

    Yield

    58.2%

    Russell 2000

    26.9%

    Barclays Corp High

    Yield

    5.0%

    Russell 2000 Value

    18.1%

    Russell 2000

    38.8%

    S&P 500

    13.7%

    S&P 500

    1.4%

    Russell 2000 Value

    23.5%

    S&P 500 Growth

    9.1%

    Russell 2000 Value

    -28.9%

    Russell 2000

    Growth

    34.5%

    Russell 2000 Value

    24.5%

    S&P 500 Growth

    4.7%

    S&P 500 Value

    17.7%

    Russell 2000 Value

    34.5%

    S&P 500 Value

    12.4%

    Barclays Aggregate

    0.5%

    S&P 500 Value

    20.8%

    Russell 2000

    Growth

    7.0%

    Russell 2000

    -33.8%

    MSCI EAFE

    31.8%

    MSCI Emerging Markets

    19.2%

    S&P 500

    2.1%

    MSCI EAFE

    17.3%

    S&P 500 Growth

    32.8%

    Barclays Aggregate

    6.0%

    MSCI EAFE

    -0.8%

    Russell 2000

    18.4%

    Barclays Aggregate

    7.0%

    S&P 500 Growth

    -34.9%

    S&P 500 Growth

    31.6%

    Barclays Corp High

    Yield

    15.1%

    S&P 500 Value

    -0.5%

    Russell 2000

    16.3%

    S&P 500

    32.4%

    Russell 2000

    Growth

    5.6%

    Russell 2000

    Growth

    -1.4%

    S&P 500

    15.8%

    S&P 500

    5.5%

    S&P 500

    -37.0%

    Russell 2000

    27.2%

    S&P 500 Value

    15.1%

    Russell 2000

    Growth

    -2.9%

    S&P 500

    16.0%

    S&P 500 Value

    32.0%

    Russell 2000

    4.9%

    S&P 500 Value

    -3.1%

    Russell 2000

    Growth

    13.3%

    S&P 500 Value

    2.0%

    Russell 2000

    Growth

    -38.5%

    S&P 500

    26.5%

    S&P 500

    15.1%

    Russell 2000

    -4.2%

    Barclays Corp High

    Yield

    15.8%

    MSCI EAFE

    22.8%

    Russell 2000 Value

    4.2%

    Russell 2000

    -4.4%

    Barclays Corp High

    Yield

    11.8%

    Barclays Corp High

    Yield

    1.9%

    S&P 500 Value

    -39.2%

    S&P 500 Value

    21.2%

    S&P 500 Growth

    15.1%

    Russell 2000 Value

    -5.5%

    S&P 500 Growth

    14.6%

    Barclays Corp High

    Yield

    7.4%

    Barclays Corp High

    Yield

    2.5%

    Barclays Corp High

    Yield

    -4.5%

    S&P 500 Growth

    11.0%

    Russell 2000

    -1.6%

    MSCI EAFE

    -43.4%

    Russell 2000 Value

    20.6%

    MSCI EAFE

    7.8%

    MSCI EAFE

    -12.1%

    Russell 2000

    Growth

    14.6%

    Barclays Aggregate

    -2.0%

    MSCI Emerging Markets

    -1.8%

    Russell 2000 Value

    -7.5%

    Barclays Aggregate

    4.3%

    Russell 2000 Value

    -9.8%

    MSCI Emerging Markets

    -53.2%

    Barclays Aggregate

    5.9%

    Barclays Aggregate

    6.5%

    MSCI Emerging Markets

    -18.2%

    Barclays Aggregate

    4.2%

    MSCI Emerging Markets

    -2.3%

    MSCI EAFE

    -4.9%

    MSCI Emerging Markets

    -14.6%

    Callan Periodic Table of Investment Returns Annual Returns for Key Indices Ranked in order of Performance

  • 16

    Biographies

    Ho Hwang is a vice president and a non-U.S. equity investment consultant in the Global Manager Research group. Ho joined Callan in 2012. He is responsible for research and analysis of non-U.S.

    equity investment managers and assists plan sponsor clients with non-U.S. equity manager searches.

    Ho regularly meets with investment managers to develop an understanding of their strategies, prod-

    ucts, investment policies and organizational structures. Prior to joining Callan, Ho worked as a senior

    investment analyst for Progress Investment Management Company. Ho earned a BA in Economics from

    University of California at Davis.

    Andy Iseri, CFA, is a senior vice president and a non-U.S. investment consultant in Callans Global Manager Research group. He is responsible for research and analysis in the non-U.S. and global asset

    class including developed and emerging equity, issues surrounding currency management, as well as

    matters related to ESG investing. He oversees manager searches, conducts on-site visits, and attends

    finalistinterviews.Andyisashareholderofthefirm.PriortojoiningCallan,Andyspentsixyearsselecting

    and evaluating domestic and international equity managers for the California State Teachers Retirement

    System.Prior to that,Andymanagedandtradeddomesticfixed incomeassetsatCalSTRS.Healso

    assisted in the plans currency, securities lending and credit enhancement programs. Before joining

    CalSTRS investmentdivisionAndywasaSeniorAccountant in theplansbenefitaccountinggroup.

    Andy earned a BS in Business Administration - International Business at California State University,

    Sacramento. He belongs to CFA Institute, CFA Society of Sacramento, and earned the right to use the

    Chartered Financial Analyst designation.

    Lyman Jung is a vice president and a non-U.S. equity investment consultant in Callans Global Manager Research group. He is responsible for research and analysis in the non-U.S. and global asset classes

    including developed and emerging markets. In this role, Lyman meets regularly with investment manag-

    ers to develop an understanding of their strategies, products, investment policies and organizational

    structures. Prior to Lymans current role, he was the Operations Manager for the group where he man-

    aged the groups analyst team and coordinated search workflow. His responsibilities also included

    qualitative and quantitative analysis of investment managers and the production of research and client

    reports. Lyman earned his B.A. in Economics from the University of California, Los Angeles and is a

    Level III candidate in the CFA Program.

  • 17Knowledge. Experience. Integrity.

    Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational pur-poses only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Investments Institute (the Institute) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institutes permission. Institute clients only have the right to utilize such material internally in their business.

    If you have any questions or comments, please email [email protected]

    About Callan

    Callanwas foundedasanemployee-owned investment consultingfirm in1973.Ever since,wehave

    empowered institutional clients with creative, customized investment solutions that are uniquely backed

    by proprietary research, exclusive data, ongoing education and decision support. Today, Callan advises

    onmorethan$1.8trillionintotalassets,whichmakesusamongthelargestindependentlyownedinvest-

    mentconsultingfirmsintheU.S.Weuseaclient-focusedconsultingmodeltoservepublicandprivate

    pensionplansponsors,endowments,foundations,operatingfunds,smallerinvestmentconsultingfirms,

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    About the Callan Investments Institute

    The Callan Investments Institute, established in 1980, is a source of continuing education for those in

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    investments industry.

    2016 Callan Associates Inc.

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