Talking Emerging Markets ETFs With Richard Kang

by on April 28, 2010 | ETFs Mentioned:

Richard Kang is the Chief Investment Officer and Director of Research at Emerging Global Advisors, LLC.  He recently took time out of his busy schedule to talk about emerging market ETFs with ETF Database.

ETF Database (ETFdb): Historically, most asset allocation strategies have called for U.S. investors to make significant allocations to U.S. equities.  Are U.S. investors guilty of a “home country bias”?  In general, do investors maintain sufficient exposure to emerging markets?

Richard Kang (RK): That is a great and fundamental question. We are in an environment now where portfolio construction is extremely difficult. It is a low yielding, low return environment, where so many investments have a high correlation. That means that portfolio theory and the concept of diversification need to be considered with a more thoughtful approach.

Thinking about what is commonly the “home bias” portfolio – if you’re American or otherwise – it makes sense to have more of your investments in your currency because when you retire, you’re going to be spending that kind of currency.

But if there is a predominant view that the U.S. dollar is at best stabilizing, but at worst continuing to decline versus other currencies, then there’s a problem because your home bias portfolio is degrading. And if you have foreign exposure, it actually enhances returns in relation to the reduced U.S. dollar. If the dollar is increasing, then you want to have a home bias situation – in that scenario, foreign exposure returns would be degrading. So that’s an important concept.

Now with regard to concerns about the equity risk premium, we had ten to twelve years of zero percent returns. That’s a real concern. You ask about sufficient exposure to emerging markets.  Well, the reality is that most investors who try to diversify internationally get into Europe, the UK, and Japan.

That’s where the big exposure is when they get into something like an EAFE fund. Europe is a big mess. In the UK and Japan, the unemployment is just as bad as in the U.S., and the outlook for growth is quite poor. The real GDP forecast of bigger numbers is coming from the emerging markets. Furthermore, we can see that the forward-looking equity risk premium looks to be in the low double digits for much of the developed world whereas in the developing markets the potential is much greater for an equity risk premium somewhere in double digit territory; which is what investors need based on their forward looking liability stream.

ETFdb:  What do you think would be an appropriate allocation to emerging markets as far as a range of percentages?

In general, it’s true that emerging markets, whether it be currency, fixed income, or equity, have greater volatility than the majority of other asset classes. So if the objective of the investor is that of greater acceptance or allowance for volatility–usually through a longer time horizon and–then that could allow for a greater weight to emerging markets. An aggressive investor might top out somewhere close to a third of their portfolio, whereas a more risk adverse investor would put something more minimal such as five percent. That’s a pretty wide range.

Many investors think about a GDP weighted portfolio, where, not too long ago, 50% of global GDP came from the U.S.  So you’d have half of your portfolio in equities in the U.S. The reality now, however, is that roughly one third of global GDP is coming from emerging markets. So this one third maximum that I suggested might actually be a pretty good average, not a maximum weight.

Most investors have a psychology within them that emerging markets are volatile, not really recalling that in the past decade U.S. markets have been cut in half twice: the tech bubble bursting in 2001, and then the financial crisis of 2008–actually worse than negative 50% returns if you consider the NASDAQ. If they can handle that kind of volatility, or downward volatility in particular, I’m pretty sure that they can handle the emerging market volatility. And when they think about certain risks like political risk commonly associated more with emerging markets, I often ask: do you feel that much better for the political risk in the U.S. or the mess that you see in Europe?  Essentially, where you have most of your money?

ETFdb: Your firm, Emerging Global Advisors, has a slightly different idea of what qualifies as an emerging market. How does the composition of EGA’s ETFs differ from other emerging markets products?

RK:  The emerging markets change in time. For many investors who have never actually been there, that is hard to conceptualize. I grew up visiting the Far East and seeing, for example, South Korea change from a nation of thatched roofs to everything being cement and steel. On the other hand, in a place like the Philippines, you see very little growth in relative terms versus Korea. So you can see the relative change in infrastructure in one place versus the other; wealth creation in one place versus the other.

Investors need to understand that not everything is static, and so a country like South Korea that was once an emerging market, no longer is. In certain indices, such as the widely-followed MSCI Emerging Markets Index, South Korea still holds a dominant position. Neither the International Monetary Fund (IMF) nor Dow Jones—the index provider used by Emerging Global—believe that South Korea is still an emerging market. They believe that South Korea, Taiwan, and Israel have moved from developing countries to developed countries.  At one point, centuries prior to the industrial revolution, Europe was a developing region. The U.S. was a frontier market at best.  In relative terms many of today’s emerging markets were dominant economies at that time. Things change.

Back to the present,  if you are able to physically visit any of these three newly developed countries, then you know that poverty to a certain degree is non-existent. It is mainly a population of middle-income earners who are well-educated, and whose locales have great infrastructure. Their airports are better than ours, and you can just see the difference.

That’s the reality. If you want a pure emerging market play, you don’t want exposure to those countries, because they are not the growth drivers of the emerging markets anymore.

ETFdb: One of the major themes behind investments in emerging markets has been ongoing urbanization. How has the rural vs. urban composition of BRIC nations changed, and what impact will this have on emerging market investments going forward?

RK: The numbers are mind boggling. We know China is a billion-plus nation. India is not as big but it’s growing faster, so the numbers are impressive there as well. Let’s focus on China. The urbanization move to the coastal areas is pretty much done. More people will move there, but the people talking about the real estate bubble should realize that it’s not everywhere, it’s primarily in certain sections of Shanghai and a small number of other large mega-cities.

What we know is that the real growth is in the interior: there are these “million plus” cities, and there’s going to be more than a hundred of them. And investors have to understand that we’re talking about cities like Chicago and Atlanta all over China.

How can that be possible?  Well, we know it’s possible because there are roughly 750 million people in the interior of China who live in relatively poor, rural areas. I’m not saying that all of them are going to move to the city, but let’s say half of them do: 375 million people, which is very reasonable based on the history of what we’ve seen in other urbanized nations. That’s greater than the population of the U.S. Just think of every person in the U.S. moving to the city, buying a car, and living the urban life. That’s why the importance of China and their consumer is the focus now. General Motors, Coca Cola, etc. they’re all focused over there. It’s common sense.

We know that the major transition story on the planet right now is the fact that the American consumer has to save more and spend less, because that is the only way to fix the structural imbalances that exist in the country right now.  That also holds true for Europe, the UK, and Japan. There’s just no way around that unless relying heavily on the Chinese and other foreign creditors is a practical long term solution.  Everyone has finally realized after the crisis of 2008 that these imbalances have to be fixed.

Thankfully in China, a big portion of the rural poor–not necessarily all 750 million of them, but a big slice–can compensate for what’s happening in the U.S.  These are people who have been traditionally saving more, and spending less. Now, through the greater freedom of having more money, they can spend more and save less in aggregate. And that means that the government will have to then provide what they need: improved infrastructure, more subway lines in the interior, better healthcare, improved and expanded power grids to limit blackouts, etc. This growing middle class is beginning to live something that we would consider a more modern, middle class life.

If that happens, then the world economy is fine. If the Chinese consumer does not pick up the slack, then we have a real problem in the globe because somebody has to compensate for reduced demand within the developed world’s consumer sector.

ETFdb: EGA recently launched ETFs focusing on the infrastructure sectors of China (CHXX) and Brazil (BRXX), and has filed for a similar fund focusing on India.  Why the focus on the infrastructure sector?

RK: This transitional process that I’ve been talking about has only gone so far. To this point, infrastructure in the emerging markets has been predominantly a private equity business. Now we know that Brazil has a new almost $878 billion project, PAC 2. Part of it is being attributed to the World Cup and the Olympics, and part of it is driven by a greater need to move assets around in the continent and globally. China has greater growth in their country because of the rapid urbanization, but like I said there are people in the interior who need infrastructure. But in both cases infrastructure was the means to get through the recent crisis. You had the government spending on fixed assets and building bridges because they could not really count on any consumer spending.

That story continues now because of the growing population. Even if it wasn’t growing, even if it was just staying where it was, it’s still a large population, with many people moving from lower to middle income. And as you have more money in your wallet, you become empowered. You say, “I should not have blackouts, or live in these types of conditions. I have relatives living in North America. They live this kind of life, and I should live that kind of life too.”

So to avoid social unrest, in whatever form it is, the governments have no choice but to improve infrastructure. And part of this imperative is to also continue the momentum of their economic growth, which can include exports. Even though they are trying to rely less on the American consumer, they might rely on exports to other emerging markets. For example, Brazil has plenty of iron ore from Vale as well as oil from Petrobras that has to get to China. So part of the infrastructure is not just moving people around through subways and airports, but moving natural resources through pipelines and shipping ports.

Consider the scale of populations in these countries and the infrastructure growth stories over history in any of the developed economies as a guide.  Yes, this is a story for today but the potential for the longer term is quite intriguing.

ETFdb: Some very interesting thoughts. Thanks for taking the time to discuss.

Jared Cummans and Imran Mohammed contributed to this article.

Disclosure: No positions at time of writing.