Risks and Rewards in Emerging Equity Markets
30 March 2012
Main findings
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In a perfect global capital market with identical consumption opportunity sets across countries, all stocks and national equity markets should be priced according to their covariance (beta) with the world market portfolio. In this frictionless model, it is optimal for investors to hold stocks in proportion to their market capitalisation weights, including emerging market equities.
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The model described above, which is sometimes called the international capital asset pricing model (international CAPM), fails to explain the cross-section of international equity market returns and is also inconsistent with the empirical tendency of investors to prefer their home equity market (or countries close and similar to the home market). This could be due to departures from perfect market integration, also called market segmentation.
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The market segmentation literature initially focussed on explicit barriers to investing internationally and the diversification benefits from the removal of those restrictions. The early literature also highlighted that emerging equity market return distributions often exhibit fatter left-hand tails and greater negative skewness relative to developed markets. The differences in these statistical patterns were attributed to currency risks, liquidity, contagion, tail risks and structural breaks.
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Theoretically, these risks should be compensated with higher long-term returns, but data on the realised excess return of emerging versus developed markets is inconclusive and sample-dependent. Over the longest available history, the realised risk premium is not statistically different from zero.
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As explicit international investment restrictions eased over recent decades, implicit impediments to international diversification have received greater attention. In emerging equity markets, investors should pay particular attention to two types of such implicit barriers: the risk of expropriation by the sovereign and corporate insiders. Conventional wisdom may suggest that these risks should be compensated with higher returns. However, there is mixed empirical evidence on whether investors are compensated for taking sovereign risk. Moreover, there are theoretical and empirical reasons to believe that weak investor protection and corporate governance are not rewarded with higher returns for minority investors. Overweighting such risks may also be at odds with an asset owner’s preferences for promoting good governance and social and environmental development.
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The theoretical and empirical arguments in favour of a substantive strategic departure from the investable capitalisation-weighted allocation to emerging markets are not strong.