EMERGING EQUITY MARKETS: BACK TO THE FUTURE? MOUNTAIN PUBLIC EMPLOYEES RETIREMENT SYSTEMS FORUM April 27-28, 2008, Denver, Colorado Professor Michael Palmer Leeds School of Business University of Colorado at Boulder

Goals of this Presentation To offer some insights into the emerging market phenomenon. To discuss some practical issues involved in constructing a globally diversified portfolio with emerging market equities. To examine emerging market returns. To look at short term threats to emerging market returns.

Quick History of Emerging Markets In the late 1980s, emerging markets became the “new frontier of global investing.” From the late 1980s to the early 1990s, these markets exhibited “spectacular returns.” However, by the mid-1990s, problems arose, as emerging countries moved from one crisis to the next: The Mexican peso devaluation of The Asian financial crisis of The Russian ruble devaluation and debt default of The Argentina debt crisis of In 2002, emerging markets emerged for the second time as the “new frontier.”

MSCI Emerging Market Index,

Why Consider Global Portfolios? Investors have long been aware of the “theoretical” benefits of adding foreign stocks to a portfolio. According to “portfolio theory,” international diversification can reduce the risk (volatility) and increase the return when compared to a single domestic market portfolio. The topic for us today is what are the issues in using the emerging markets for diversification purposes.

How Does Diversification Work? Essentially, global diversification works if equity markets in different countries don’t move together much. In theory, as long as economic, political, institutional, financial and psychological factors affecting security returns vary across countries, stock markets will show relatively low correlations to one another. Question: What does the emerging market correlation picture look like?

Correlation of Emerging Markets to U.S. Market, To June 30, 2007 MSCI Emerging Markets Index to the S&P to June 30, 2007: to June 30, 2007:.551 The MSCI (Morgan Stanley Capital International) Emerging Market Index consists of indices representing 26 emerging economies: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela. Combined the MSCI represents over 700 companies. The index has as its base (=100) December 31, 1987.

First Practical Issue Bad News: As a group, emerging equity markets are more closely related to the U.S. equity 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 then in earlier periods. Good News: Correlations are not perfect (not 1); thus diversification benefits are still possible. But More Bad News: We can expect these correlations to continue to creep up in the years ahead.

Next Issue. What About Returns? Decade of the 1990s: Emerging markets recorded a dismal annual return of 0.18% in U.S. dollar terms. Last Ten Year Returns: From January 1998 to December 2007, emerging country stock markets recorded an annualized return of 14.3% in U.S. dollar terms. Last Five Year Returns: For the five years ended December 31, 2007 emerging markets delivered an average annualized return of 37% a year in U.S. dollar terms.

Emerging Market Returns in 2006 and 2007 with Specific Markets In 2006, the MSCI Emerging Markets Index rose 30%: China: 140% Russia: 70% India: 60% Brazil: 45% In 2007, the MSCI Emerging Markets Index rose 39%: China: 110% Brazil: 71% India: 67% Russia: 19%

But How Do Emerging Market Returns Compare to Developed Markets? Annual Returns for Period Ending December 31, Years 5-Years 3-Years 4Q2007 MSCI Emerging 14.3% 37.0% 35.1% 3.7%* S&P % 13.1% 8.9% -3.3%* MSCI EAFE** 9.0% 22.1% 17.3% -1.7%* *Quarterly data not annualized **MSCI EAFE (Europe, Australasia and the Far East) comprises 21 country indices representing developed markets outside of North America. Japan and the UK are the two biggest EAFE markets.

Returns for the 1Q2008 Not as Good MSCI Emerging Markets-9.6% MSCI BRIC* -16.8% China: -28.8%; India: -22.2%; Russia: %; Brazil: -1.4% S&P % MSCI EAFE-8.4% MSCI Japan-5.8% *MSCI BRIC comprises the following four countries (with % of index): China 36%, Brazil 28%, Russia 20%, and India 16%. The index is made up of 124 stocks.

Summary of Historical Returns Over the last 10 years, emerging markets as a group have delivered relatively high annualized returns compared to the U.S. market and to other developed markets. HOWEVER, for the first three months of 2008, emerging market returns have fallen relative to the U.S. and to other developed markets. Question: Are emerging markets about to repeat the decade of the 1990s? Next Issue: In addition to these historical returns, we also need to consider the volatility (i.e., risk) of emerging market returns.

Comparison of Market Volatility *A measure of the dispersion of a set of data from its mean. The higher the standard deviation, the greater the volatility. Emerging Markets 1990’s5 Years Ending December 31, Year Ending December 31, 2007 Annual return 0.18% 37.44% 33.08% Standard* Deviation 24.55% 17.69% (Annualized) 1.54% (Daily) 32.57% (Annualized) 2.06% (Daily) S&P 500 Annual return16.14% 13.10% 5.49% Standard Deviation* 13.54% 9.95 % (Annualized) 0.83% (Daily) 15.99% (Annualized) 1.00% (Daily)

Second Practical Issue Good News: Over the last 10 years, emerging markets have offered higher (average) returns than those in the United States. Bad News: These higher returns have been achieved with greater volatility (i.e., greater risk); about double that of the U.S. market! Potential Good News: Greater volatility means there is the potential, if you make the right investment decision, for really big returns. Potential Bad News: If you make the wrong investment decision, you in for really big losses!

Next Issue: What are the Best (?) Models for Selecting Emerging Markets? Studies show that for emerging markets, country performance is by far the biggest driver of international 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, as investors we should focus on COUNTRY performance.

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

Last Issue: Exchange Rates Since you’re based in the United States, you’re ultimately concerned with the U.S. dollar return on your emerging market investments. Question? Do exchange rates have an impact on your emerging market returns? Answer: Definitely, YES and in some cases, a large portion of the total return is attributed simply to exchange rate changes.

Exchange Rate Impacts in 2007 CountryLocal Currency Return U.S. Dollar Return Contribution of Exchange Rate (%) China96.6%110.3%12.4% Brazil41.2%70.5%41.6% India48.4%66.6%27.3% Russia10.7%19.2%44.3% Mexico 8.5% 7.6%11.8% Venezuela-27.4%-55.9%51.0%

Fourth Practical Issue Bad News: We can see that if the value of the foreign currency of the emerging market country declines against the U.S. dollar, your U.S. return will be lower (Mexico and Venezuela in 2007). Good News: We can see that if the value of the foreign currency of the emerging market country increases against the U.S. dollar, your U.S. dollar return will be higher (the big 4 in 2007). Very Bad News: Forecasting specific currency exchange rates against the dollar is difficult. Potentially Good News: In general, the dollar should remain weak in 2008 and thus add to overall emerging market returns.

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 over longer term investment horizons. However, there are significant shorter term “threats” facing emerging markets today.

Will These Short Term Threats Take Us Back to the Future? Apart from political uncertainties, the major current threat to emerging market performance arises from the increasingly negative outlook for economic growth in the developed world, and especially in the United States. Why? Over the short term, the high export focus of many emerging markets can only be partially offset by growth in their domestic markets. Thus, the ongoing “trade related coupling” of emerging market economic fortunes to the United States and the rest of the developed world will continue to represent a major threat to their equity markets.

BACK TO THE FUTURE???

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. The IMF defines emerging markets as “countries with low to middle per capita income that have undertaken economic development and reform programs and have begun to "emerge" as significant players in the global economy.” Of the 130 countries that the international financial community generally considers to be emerging, approximately 40 currently have stock markets.

Asian Tigers The earliest interest in “emerging markets” can be traced to the success of the four Asian Tigers: South Korea, Taiwan, Hong Kong, Singapore. These four economies used an export-driven strategy to achieve phenomenal growth between the early 1960s and 1990s. Newport Tiger Fund was established in However, the Asian Currency Crisis of 1997 hit these economies hard, especially South Korea.

BRICs Recently, emerging market interest has shifted to the BRIC countries. BRIC is an acronym for the combined economies of Brazil, Russia, India and China. The general consensus is that the term was first used in a Goldman Sachs report in 2003, which speculated that by 2050 these four economies would be wealthier than most of the current major developed countries. The BRIC thesis argues that China will become the world's dominant supplier of manufactured goods, that India will become the world's dominant supplier of services. Additionally, Brazil and Russia will become dominant as suppliers of raw materials.

APPENDIX 2: A LOOK AT GLOBAL DIVERSIFICATION AND SECURITY RETURN CORRELATIONS OVER TIME

Historical Review of Security Return Correlations In the 1970s, when the investing world began to discover the benefits of global diversification, security returns showed little correlation Data; U.S. Stock Market to: German Market: Japanese Market: United Kingdom Market: 0.279

Late 1980s and into the 1990s During 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 correlation data of US markets to: German market: 0.45 (0.170) Japanese market: 0.31 (0.137) United Kingdom market: 0.58 (0.279)

Correlation of Developed Markets to U.S. Market, To June 30, 2007 MSCI EAFE Index to the S&P to June 30, 2007: to June 30, 2007: to June 30, 2007:.660 The MSCI (Morgan Stanley Capital International) EAFE Index consists indices from 21 developed markets: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, United Kingdom. The index excludes those from the U.S. and Canada. Combined the MSCI EAFE represents over 1,100 companies. The index has as its base (=100) December 31, 1969.

APPENDIX 3: WHAT TO FOCUS ON WHEN ASSESSING COUNTRY RISK

What Country Factors Might We Focus On? Political Risk: Be on the alert for possible adverse changes in the political environment of the host country. Thailand in 2006, Turkey in Globalization Risk: Look for 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.

Inflation as a Risk Factor Inflation Risks: Equity markets and investors do not like high and rising rates of inflation. Examine each country’s inflation rates: 2007 Latest Forecast for 2008* Brazil 3.6% 4.6% 4.7% Russia 8.9% 12.7% 12.5% India 6.5% 5.5% 5.8% China 4.7% 8.7% 4.5% *Economist Forecast

APPENDIX 4: IMPACT OF EXCHANGE RATES ON US DOLLAR RETURNS FOR SELECTED YEARS

Exchange Rates Impact in 2005 Region2005 Return in Local Currency 2005 Return in US dollars Americas7.6%8.2% Asia-Pacific27.2%18.3% Europe/Africa/ Middle East 23.6% 8.1% Average16.0%10.0%

Exchange Rates Impact in 2006 Region2006 Return in Local Currency 2006 Return in US dollars Americas16.8%17.0% Asia-Pacific24.6%33.8% Europe/Africa/ Middle East 19.5%27.1% Average19.1%23.8%

Exchange Rates Impact in 2007 Region2007 Return in Local Currency 2007 Return in US dollars Americas 8.8%11.6% Asia-Pacific29.1%36.5% Europe/Africa/ Middle East 4.3%13.2% Average12.4%18.3%