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How emerging markets benchmarks misread economies

As pension funds around the world shift international equity allocations to emerging markets, they should be increasingly cautious about the benchmarks in use, according to Conrad Saldanha, the New York-based portfolio manager for emerging markets equities at Neuberger Berman.

Stock markets are not always representative of the underlying economy and not all emerging markets are equal, Saldanha said.

“There’s an increasing scepticism about the value of benchmarks because of their skew towards the developed world,” he continued. “The benchmarks are inefficient.”

Within emerging markets the benchmarks are also skewed towards large-cap stocks, by definition, which means a skew towards more secular export-type growth.

For instance, Brazil’s gross exports make up 11 per cent of the country’s GDP but net exports are zero, according to estimates for 2010. Yet, the Brazilian stock market consists of 54 per cent commodities.

Saldanha’s solution is to have a process which gears emerging markets investments towards domestic rather than export growth, which has the added advantage of leading to a portfolio with less cashflow volatility.

In many markets, such as China, the large-cap skew means a heavy weighting to financials, whose performance can be geared to government spending. Saldanha said the restricted market structure of China, dominated by the  shares market for local investors, tends to cap its return potential.

Nevertheless the growth story of China cannot be ignored, particularly as urbanisation reflects increasing domestic consumption.

About one-third of Neuberger’s emerging markets portfolio, which totals about $1 billion, is not in the MSCI benchmark. The firm allows itself up to 20 per cent which can be invested in developed markets, which tend to be stocks with emerging markets exposures. It also currently has 8.5 per cent in frontier markets, which is likely to inch up in the short term.

Saldanha is more concerned about European emerging markets, due to Greek contagion, than China’s economy slowing down any time soon.

“This may lead to a sell-off in risk,” he said. “But that’s when emerging markets get mispriced. We tend to be a bit contrarian. “It’s always darkest just before the dawn.”

A better predictor of returns than GDP growth is earnings per share growth, Saldanha said. “We want to see margin improvement; that’s what will drive increased returns.”

The most important information is “who has the pricing power”.

Given that a large proportion of emerging markets companies “perhaps more than half” are controlled by founders, families or governments, governance is an important issue.

“You have to look at their track records as shareholders,” Saldanha says.

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