Adding Value to Global Developed Portfolios with Emerging Market Stocks

August 1, 2013

McKinley Capital Management, LLC (“McKinley Capital”) believes that global developed portfolios can be enhanced with the addition of emerging market (“EM”) stocks. There are two basic approaches. First, a global developed mandate can be expanded to a global all country mandate with the addition of EM stocks. In such a case, it may be appropriate to shift a manager’s benchmark from the MSCI World Index to the MSCI All Country World Index. A second approach is to retain a global developed mandate for most of the assets, but break off a portion of the assets and invest that portion with a dedicated EM manager or managers. There are advantages and disadvantages to both approaches. McKinley Capital provides both alternatives for its clients.
Many analysts agree that increasing the diversification of a portfolio improves an investor’s overall risk/return tradeoff. Based on this concept, McKinley Capital reviewed several widely used equity indexes during the testing period from January 31, 1995 to June 30, 2013. Specifically, McKinley Capital analyzed the impact of adding EM stocks to a developed global portfolio and then considered various strategies to determine the effectiveness of the approaches.

1308 Adding Value-01 Tab1

McKinley Capital calculated passive annualized returns and standard deviation of returns for several important market indexes during the testing period (see Table 1 above). The MSCI EAFE Index indicated a Sharpe ratio of 0.14. The MSCI World Index, a global developed index that combines the developed EAFE, U.S. and Canadian securities markets, produced a global developed Sharpe ratio of 0.26.
This initial comparison appeared to show some gains due to diversification within the developed world. During the testing period, the risk of the global developed portfolio was somewhat less than the risk of the developed EAFE only index, while the return was higher. Still, during the testing period, return correlation was rather high. Table 2 (below) reflects that over the testing period, there was a 96% correlation between the MSCI EAFE and MSCI World returns. Due to globalization, this phenomenon of increasingly high return correlation across the developed countries seems to persist. Would the addition of EM stocks provide additional diversification benefits?

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Surprisingly, it appeared that the passive addition of EM stocks using a market capitalization weighted approach did not increase the benefit of diversification in a passive global developed portfolio during the testing period. The MSCI All Country World Index combines both developed and EM stocks weighted by market capitalization. At the end of the testing period, EM stocks comprised approximately 11.2% of this index, with the percentage of EM stocks steadily increasing from approximately 7% of the index in 1995. The Sharpe ratio indicated by the MSCI All Country World Index was 0.25 compared to 0.26 for the MSCI World Index. During this period, not only was there no pick-up in return, return volatility actually increased.

When faced with increasingly correlated markets, a global plan sponsor might consider assuming the increased risk (market risk, operational risk, sovereign risk, etc.) of adding EM stocks to improve the risk/return trade off of the portfolio. However, the strategy of adding MSCI EM type securities at market capitalization weights would seem to offer few of the desired benefits.
One possible concern with the passive addition of EM stocks might be the type of EM stocks added to the MSCI World Index to create the MSCI All Country World Index. Since all of these indexes are market capitalization weighted, it is quite likely that the largest and most multi-national companies dominate the EM portion of the broad based MSCI All Country World Index.

Approximately 20% of the stocks in the MSCI EM Index comprise over 60% of the market capitalization. These large stocks might provide the least potential for diversification. In fact, during the test period, the return correlation between the MSCI EM index and the MSCI EAFE index was 82%. Such a correlation may suggest that a strategy which looks beyond the passive addition of a market capitalization weighted investment in EM stocks could be beneficial. An active manager moving from an MSCI World to an MSCI All Country World mandate may wish to consider an all cap strategy to potentially benefit from the opportunity to select additional small, local market oriented, and specialized EM stocks.

McKinley Capital fully supports the notion of broad based global investing. However, the firm subscribes to the concept that an investor might need to invest in more than the largest EM stocks. In the firm’s experience, smaller, and in some cases, more lightly traded EM stocks often provide a superior risk/return trade-off. To fully exploit this view, McKinley Capital manages both broad-based global and non-U.S. portfolios, as well as dedicated all cap EM portfolios using a proprietary equal active weight (EAW) philosophy. For an investor who can consider EM stocks, this all cap approach often provides more exposure to smaller stocks that are traded less frequently than the larger MSCI EM Index stocks.

To demonstrate, McKinley Capital divided the MSCI EM Index into market capitalization weighted quintiles and constructed five equally weighted EM portfolios, one composed of the stocks from each quintile. A single equally weighted portfolio using all of the stocks in the index was also constructed. As reported in Table 3 (below), the test period results are dramatic. The single equal weighted portfolio had a Sharpe ratio 0.30. The return was much higher than the MSCI capitalization weighted EM Index, with a similar level of risk. The largest market capitalization portfolio had a Sharpe ratio of 0.23 and the smallest market capitalization portfolio had a Sharpe ratio of 0.43. Over the test period, the smaller EM stocks produced the best performance with only a marginal increase in risk. Clearly, the ability to invest in EM stocks of all market capitalizations led to superior opportunities during the testing period.

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Next, McKinley Capital blended the equal weighted EM portfolio with the developed MSCI World Index in a constant 10%/90% ratio. The Sharpe ratio of the blended portfolio was 0.28, thus outperforming the original set of index portfolios. The blended portfolio had better risk/return characteristics than the market capitalization weighted broadbased MSCI All Country World Index. Compared to the developed only MSCI World Index, the blended portfolio added 44 basis points of annualized return. This result was achieved with only a small (10%) allocation to EM stocks.

Additionally, the firm looked at the performance of EM stocks by volume and analyst coverage quintiles (see Tables 4 and 5 below) during the testing period. As was the case with market capitalization, less actively traded EM stocks outperformed more actively traded EM stocks, and less covered EM stocks outperformed EM stocks with greater analyst coverage. Also, stocks in the lower trading volume and analyst coverage quintiles had lower return standard deviation than stocks in the higher quintiles. The exception is that returns deteriorated in the lowest trading volume and analyst coverage quintiles.

This data illustrates why McKinley Capital has implemented an active EM investment strategy that seeks opportunities as they arise throughout the emerging world, without a particular focus on the largest EM stocks. At the same time, the
data also illustrates why it is not necessary for a manager to position EM names that have little or no trading volume or analyst coverage. For reference, as of 7/12/2013, McKinley Capital owned 79 stocks in its dedicated EM strategy. Of those 79 stocks, 44 had a market cap of less than $3 billion, while 60 had a market cap of less than $10 billion.

Based on McKinley Capital’s analysis, an investor seeking a superior risk /return trade-off through EM investing should consider employing investment managers with the capacity to: (1) invest across the entire range of EM securities; (2) employ an equal or equal active weight philosophy; and, (3) successfully incorporate a selection process which may otherwise add value. Such managers can offer either broad based global portfolios which contain a wide selection of emerging market names or separate global developed and dedicated EM portfolios.

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DISCLOSURE
McKinley Capital Management, LLC (“McKinley Capital”) is a registered investment adviser under the U.S. Investment Advisers Act of 1940. McKinley Capital is not registered with, approved by, regulated by, or associated with the Financial Conduct Authority (“FCA”) or the Prudential Regulation Authority (“PRA”). Neither the FCA nor the PRA have commented on the firm, the content of any marketing material or any individual suitability assessments.

All information contained herein is believed to be acquired from reliable sources but accuracy cannot be guaranteed. This presentation is for informational purposes only, and was prepared for academic, financially sophisticated, and institutional investors. It is not intended to represent specific financial services or recommendations for any targeted investment purposes. This material may contain confidential and/or proprietary information and may only be relied upon for this report. The data is unaudited and may not correspond to calculated performance for any specific client or investor in referenced disciplines. McKinley Capital, nor its employees, makes any representations or warranties as to the appropriateness or merit of this analysis for individual use. Investors must seek individualized professional financial advice before investing.

Investments and commentary were based on information available at the time and are subject to change without notice. Any references to specific indexes or securities are for informational purposes only, may or may not have been owned by McKinley Capital in the past, may or may not be owned by McKinley Capital in the future and may or may not be profitable. No single security, discipline, or process is profitable all of the time and there is always the potential for loss. Past performance is not indicative of future returns. All returns are gross of investment management fees, broker commissions, taxes, and all other fees, costs and expenses associated with client account trading and custodial services, and therefore individual returns may be materially negatively affected. Returns do include the reinvestment of gains, dividends and other income.

Global market investing, including developed, emerging and frontier markets, also carries additional risks and/or costs including but not limited to: political, economic, financial market, currency exchange, liquidity, accounting, and trading capability risks. Derivatives trading and short selling may materially increase investment risk and potential returns. These risks may include, but are not limited to, margin/mark-to-market cash calls, currency exchange, liquidity, unlimited asset exposure, and counter-party risk. Future investments may be made under different economic conditions, in different securities and using different investment strategies. McKinley Capital’s proprietary investment process considers factors such as additional guidelines, restrictions, weightings, allocations, market conditions and other investment characteristics. Thus returns may at times materially differ from the stated benchmark and/or other disciplines and funds provided for comparison.

Charts, graphs and other visual presentations and text information were requested by the client and derived from internal, proprietary, and/or service vendor technology sources and/or may have been extracted from other firm data bases. As a result, the tabulation of certain reports may not precisely match other published data. Data may have originated from various sources including but not limited to Bloomberg, MSCI/Barra, Russell Indices, FTSE, APT, ClariFI, Zephyr, and/or other systems and programs. With regards to any material accredited to FTSE International Limited (“FTSE”)©FTSE [2013]: FTSE™ is a trade mark of London Stock Exchange Plc and The Financial Times Limited and is used by FTSE International Limited under license. All rights in the FTSE Indices vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE Indices or underlying data. With regards to any materials accredited to MSCI/Barra: Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent. Please refer to the specific service provider’s web site for complete details on all indices. McKinley Capital makes no representation or endorsement concerning the accuracy or propriety of information received from any other third party.

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