This piece is part of an ongoing project to identify countries
that have a potential to provide high investment returns while
exposing investors to less market risk. It constitutes part two of
my "Seeking High-Alpha, Low-Beta Countries" series - part one was
published by Seeking Alpha
Ever since I've been involved with investing, I've been on a
quest to find exceptions to the dictum that high returns are
associated with higher risks.
I believe that this is possible because one of the things
missing from the "high-risk, high-return" puzzle is the level of
risk of a particular investment in the marketplace. Sometimes a
specific investment is perceived to have significantly more risk
than it actually does. Other times the opposite is true.
Is Emerging Market Investing Risky?
My opinion is that the "average" investor exaggerates risks that
he or she
in the emerging markets, mainly because of fear of the unknown.
Mainstream media tends to promote this viewpoint as well.
Having had the perspective of an "outsider" to the mainstream
U.S. opinion, I've come to the conclusion that many are more
comfortable losing money to the "familiar" than making money from
the "unknown". If this is indeed the prevailing bias, then there is
money to be made. I realize the phrase "prevailing bias" is too
Soros-esque but I'm really talking behavioral economics here.
Of course, there are periods of euphoria when all investments
get discounted with less risk premiums than warranted, and this
includes emerging markets as well. Also emerging markets are
vulnerable to larger price moves merely because their smaller
trading "pools" are not always equipped to properly "digest"
trading decisions made by global players. However, if a U.S.
investor has ever dealt with a midcap U.S. stock, they know exactly
how that kind of volatility works.
This piece is about analyzing global data and I'm here to
provide it to you.
So, Is Emerging Market Investing Riskier Or
This is precisely what I've been trying to figure out. For that,
I've looked at betas and various other metrics along with
performance measurements during different time periods. If you're
up to analyzing more data including correlations as well as
standard deviations of different markets, I highly suggest that you
take a look at the piece published a year ago entitled,
"Calculating Country Risk Observed by Betas".
If you look carefully at the two-year and ten-year ranking
tables in the piece, you will notice that each emerging country has
a unique "risk" characteristic. Some emerging markets are "riskier"
to invest in, but some are not. In fact, some emerging markets are
equally or even less risky than certain "developed" economies,
specifically economies of the European Union.
The article comes to the conclusion that certain emerging
countries, specifically those in emerging Asia as well as Middle
East and North Africa, are perhaps less risky than we may have
initially thought. They rank better than many "developed" nations.
On the other hand, some other emerging nations are indeed riskier
than global averages.
The U.S. market constitutes a significant portion of the global
marketplace, and if we exclude U.S. data from the "independent"
world index variable in our calculations, we also get a lower risk
metric for the U.S. market. In fact, among the "developed"
countries, only U.S. and Japan are associated with the "lesser"
risk that our average investor may be interested in.
Country Performance Attribution Analysis
Last week's article lists and ranks aforementioned countries'
subsequent yearly investment returns as a follow-up on the
preceding year's article, while observing that the remarkable
performance of the "lower-risk" countries benefited tremendously
from market timing.
Standard & Poor's Index Services makes its country specific
index data available in a few currencies, and I chose data provided
in U.S. dollars. So all results implicitly assume the perspective
of the U.S. investor and that the investor chose not to hedge the
currency risks associated with these markets.
The same table from last week is reproduced below:
Country Returnsfrom December 2, 2008 to December 2,
"Raw" Return ((
"Raw" Return ((
I'm going to attempt to undertake an informal performance
attribution analysis on these returns.
As I mentioned in the article last week, there are two things
I'm concerned about: One is the fact that these returns are
measured from a rather low base. In fact, the "base" data for many
of these indices are not very different from the global market lows
of March 2009.
The other is the fact that U.S. dollar has lost significant
value to many of the currencies of these markets during the
measurement period. We should keep that in mind especially if we
want to look deeper into the relative underperformance of U.S.
equities, or the success of emerging markets vis-à-vis U.S.
equities, during this time period.
So I had to get a hold of these markets' currency data for the
periods concerning these results. I fetched all the necessary
currency data from oanda.com.
Return Diagnostics (1): Currency Performance
The next table breaks down the return metric for all markets to
see how much is attributable to respective currency movements. The
columns break down the return into three components:
First one is the local return, which is the return associated
with the home currency, second is the currency return, which is the
return of the currency with respect to the U.S. dollar. The third
component is the cross component which accounts for the effect of
the change in the local currency on the change in the local market.
In other words, it's a mathematical cross term that should be added
to the two components to come up with the U.S. return.
If you follow my stuff, you not only like looking at data, but
also like looking at how data get sliced and diced. I hear you. So
embrace for more. This time, country index returns are ranked from
top to bottom according
produced in their home currencies:
Country Returns from December 2, 2008 to December 2,
"Raw" Return ((
There is somewhat of a shift in countries' places when ranked
with respect to local returns. Some may argue that changes in
ranking should not be important because stock markets adjust for
currency devaluations or revaluations and the law of one price
should make changes in currency levels irrelevant. However, that
premise would hold only if we believed that purchasing power parity
As a side point, original regressions I ran a year ago on U.S.
returns implicitly assumed that currency fluctuations as such were
irrelevant and that PPP held. Otherwise, the model would have had
to account for currency risk as another control variable, which
would have created a different story. So the reader will have to
make do with a simple attribution analysis like this one for
The metrics in the table above tell a few narratives, and I'll
briefly summarize some I find worth mentioning. First off, some
countries' returns have been influenced by significant revaluation
of their currencies vis-à-vis the U.S. dollar, among them
Indonesia, Brazil, Australia, South Africa, Chile, and New Zealand
(34% - 42%). Secondly, South Korea, Norway, Canada, Sweden and
Switzerland show a revaluation in high teens and low twenties, and
the euro displays a revaluation of 19%.
On the other hand, India, Russia, Turkey, Mexico, Peru,
Thailand, Taiwan, Philippines, Malaysia, and Israel show remarkably
lower rates of revaluation (there is even a small devaluation in
Ruble's case) considering the ensuing buying pressure on the
emerging markets' currencies. Elsewhere, China and Hong Kong speak
From a fundamental vantage point, I have spoken out and written
about dangers of currency overvaluation in smaller emerging markets
due to global funds' rush to shallower waters creating bubbles of
sorts, specifically in relation to the Turkish economy. For
instance, I know that quite a few business players in Turkey would
react very negatively had the Turkish currency shown more
revaluation than the mere 5.7% shown in the table above during this
In order to be consistent with my country-specific evaluations,
I cannot applaud a strong currency valuation when a much longer
investment horizon is concerned (2 to 5 years and more). However,
when the local market return constitutes a greater portion of the
total return, as in the case of Brazil and Indonesia, I will be
more forgiving because it is clear that the investment remains a
bet on the country rather than on its currency. Whether I view a
currency revaluation as good or bad would also depend on whether
that specific country is experiencing a trade surplus or deficit,
but this type of analysis is beyond the scope of this piece.
However, in the cases of Australia, South Africa, and
specifically New Zealand, the currency component constitutes more
than half of the distribution of returns. Therefore it's not clear
whether the investor is making money because of a bet on that
specific country or because of a bet on that country's
Yet, a positive note for U.S. equities is due after this
breakdown. The U.S. equity performance has moved up in rank a bit
after taking care of the miserable performance of the U.S. dollar
vis-à-vis other currencies.
Return Diagnostics (2): Market Timing
Determining how much of a return is due to market timing is not
an easy job. If you are interested in my previous efforts to
determine this, I suggest that you take a look at last week's
article. That piece multiplies daily betas with the yearly global
market return to come up with such a timing metric, and subtracts
this metric from the yearly asset return to come up with an
"excess" return, but the methodology is quite suspect because of
the mingling of daily metrics with yearly returns. On top of that,
not only are betas subject to change, but alphas also tend to be
positive during good performance periods and negative during bad
performance periods. So any alpha produced may be partly or wholly
due to the right timing.
One of the more convenient ways to look at the "timing" effect
is to analyze returns from peak to peak to see whether a specific
country is outperforming or underperforming the global index during
such periods. In other words, if I lengthen my measurement period
to two years, my "base" data for country indices will capture
numbers that are very close to the world highs established in
October of 2007.
I would like to state that the initial spirit of this "country
risk" study was to capture lower-risk countries while benefiting
from the higher than warranted risk premiums that investors
required from emerging markets a year ago. I figured, while
capturing high-risk premiums (hence low valuations), why not try to
accomplish it with less risk?
So I will now look at return data from a base period when global
markets were priced closer to "perfection". This way we can have a
better idea about which country is outperforming the global index
when measured from a place close to the global peak.
For that I will lengthen the measurement period to two years as
opposed to selecting the world highs established in October 2007,
although December 2007 is close enough. (I am doing enough data
mining and slicing as it is, and don't want to add an ex-post
"selection bias" to what I'm doing.)
Below are the results. The global index return during this time
frame remains -25.6 percent:
Country Returnsfrom December 3, 2007 to December 2,
"Raw" Return ((
"Raw" Return ((
As we can see, the majority of these markets have not reached
levels observed during the highs of 2007. If we divide the 44
countries in this table into four quartiles for performance
evaluation purposes, we see that the only "developed" market in the
first quartile is Switzerland. However, Canada, U.S. and Australia
remain relatively healthy in the second quartile. This exercise
bodes badly for European countries, including those within and
around the European Union.
Nevertheless, part two of these series has established that U.S.
equities are doing better than most of their European
Below is a currency attribution analysis on this period's
returns. This time, countries are ranked according to their
respective local currency returns:
Country Returns from December 3, 2007 to December 2,
"Raw" Return ((
When global markets were discounting a financial Armageddon
almost a year ago, U.S. dollar registered significant gains. Most
of the disappointing dollar performance since then has been the
undoing of that value gain.
However, when we look closer into currency performances
registered beginning with global highs at the end of 2007, we see
that a couple of countries' currencies devalued against the U.S.
dollar and remained that way, most notable among them Turkey, South
Korea, United Kingdom, Russia, Mexico, and India (-22% to -15%).
What stroke me most about this table is that while most countries'
currencies have recovered against the U.S. dollar, the currencies
of the above-mentioned countries did not.
In fact, when country performance is measured and ranked
according to local currency returns, both Turkey and South Korea
move from the third quadrant into the first one.
As a side point, this devaluation has been an opportunity for
Turkey for improving its current account deficit standing, but
whether that alone will help the country to move towards an
export-oriented growth economy remains to be seen.
I'm no Japan expert here, but having registered a currency gain
of 28 percent against the dollar and even more against some other
currencies, there appears to be a significant overvaluation problem
in their hands. In fact, when ranked according to local returns,
the Japanese market is doing as badly as European markets.
This exercise started as a risk-ranking project and morphed into
something bigger. It's a big world out there, and it's a bigger
challenge to fit the world's supreme diversity into some type of a
quantitative model. However, calculating basic risk metrics with
available index data has been a good starting point for a top-down
analysis of the world markets.
A real-time observation of results required a further analysis
into the whys and hows of individual country performances. So I
prepared performance attribution tables to provide a snapshot of
what is going on in many global markets as well as these markets'
I must admit that performing a currency break-down analysis
raised more questions in my mind than answers I was preparing to
provide. These types of questions belong to fundamental analyses of
respective countries' economies, which is beyond the scope of this
Everyone is telling a story about the markets - that the recent
rally has been too fast, or that a correction is due. I always like
to look at numbers and hope that they will manifest a less "biased"
narrative. Via strictly looking at available data without anyone
clouding our judgment, perhaps we can better arrive at our own
version of the tale that is about to unfold.
Disclosure: No positions
Top 10 Emerging Markets Metals and Mining