Leaders Emerge From the Crisis

After two years of economic crisis, global financial markets have halted their downward slides and staged rebounds that have been nothing short of spectacular. With each passing day the markets seem to be walking out of the shadows into a better future.

Behind the recovery lurks a profound change, though. The crisis has fundamentally altered the global financial system and the traditional investment paradigm, shifting the focus of asset allocation away from strategies based on market capitalization to those geared toward economic growth. As a consequence, emerging markets should become a core element of investors’ portfolios rather than a modest diversification play.

The term “emerging market” was coined in 1981 to refer to countries and regions that were starting to enjoy faster growth as a result of economic reforms. These areas started with low levels of gross domestic product and productivity, though, and their development had relatively little impact on the global economy for some 20 years.

Throughout that period global institutional investors focused mainly on strategic asset allocation within developed markets. Mainstream fund managers took comfort in historical data showing stable returns in developed markets, believing that low volatility meant low risks. Emerging markets, by contrast, were regarded as having too much risk and uncertainty even if they offered higher returns at times. Loopholes in securities laws, thin liquidity and restrictions on capital flows made these markets less compelling on a risk-adjusted basis. As a result, most fund managers allocated no more than 5 to 15 percent of their portfolios to these markets.

Things started to change in the past decade. The Internet helped spread information and capital at the speed of light. Emerging markets increasingly integrated themselves into the global economy and became a significant force in world trade.

Over the past two years, as developed markets were weighed down by a crisis of their own creation, the emerging markets — led by the BRIC countries of Brazil, Russia, India and China — have played extraordinary roles. Financial markets can’t help but notice the increasing involvement of these countries in the Group of 20, and the role that China’s 4 trillion-renminbi ($585 billion) stimulus package has played. The growth in emerging markets has helped jump-start a global recovery as developed countries stalled.

This change of economic balance is bound to bring fresh perspectives to investment thinking. In this environment economic growth, rather than market capitalization, should increasingly become the key determinant in asset allocation.

To validate our thesis we constructed three indexes based on GDP and GDP growth rates and compared their performances since 1999. In the first index assets were allocated in proportion to the size of a country’s GDP in the previous year, as reported by the International Monetary Fund. The second index allocated half of assets according to a country’s GDP and half according to its long-term growth rate, based on IMF estimates for its GDP growth for the next five years. The third index allocated all assets according to a country’s long-term GDP growth rate.

The results were striking. All three indexes far outperformed a market-cap-weighted asset allocation model, using the S&P Global LargeMidCap index as a benchmark. The GDP-based index generated an annualized return of 7.38 percent over the past 11 years, compared with 3.28 percent for the S&P; the half-GDP, half-GDP-growth index returned 7.85 percent; and the pure-GDP-growth index returned 8.30 percent.

These figures demonstrate that asset allocation models based on market capitalization are no longer optimal in an era of globalization. Asset allocation has shifted to a dynamic pursuit of economic growth and cycles as high growth rates in emerging countries lead to the expansion of local capital markets, the rise of earnings of listed companies and higher returns for investors.

To successfully implement a dynamic asset allocation model, investors need to understand the connections between different markets, develop an unbiased view of economic cycles and learn to spot the macro factors that drive returns. They also need to pay attention to details such as market volume, capital flow restrictions, currency hedging and other factors. Our long-term GDP growth index, for instance, gives China a 26.32 percent weighting, compared with 10.99 percent for the U.S. The S&P market cap benchmark, by contrast, is weighted 40.84 percent toward U.S. companies and 2.18 percent toward Chinese ones. It is valid to ask whether China and other emerging markets have the liquidity to justify the weights implied by our growth index.

Still, smart money managers, including some sophisticated university endowments and pension fund officers, have increased their allocations to emerging markets. The new era is just getting started.

Larry Zhang is founder and CEO of China Neo Capital Management in Beijing.