A few years ago, no one had heard the term ‘BRIC’ let alone appreciated that Brazil, Russia, India and China would be key influences on the world economy and investment markets this century.
That changed dramatically in 2003 due to a landmark Goldman Sachs paper, Dreaming with BRICs: the path to 2050. Its authors mapped out gross domestic product (GDP) growth, income per capita, and currency movements in the BRIC economies through to 2050.
The results were startling. “By 2050, the list of the world’s 10 largest economies may look quite different,” the authors wrote.
“If things go right, in less than 40 years the BRIC economies together could be larger than the G6 in US dollar terms. Of the current G6, only the US and Japan may be among the six largest economies in US dollar terms in 2050. High growth may lead to higher returns and increased demand for capital. The weight of the BRICs in investment portfolios could rise sharply.”
While 2050 is a long way off, the authors’ predicted the changes would be most dramatic in the first 30 years. “As early as 2009, the annual increase in US dollar spending from the BRICs could be greater than that from the G6 and more than twice as much in dollar terms as it is now.”
In other words, the investment compass needle is swinging. Just as England grew to dominance during the 1800s and the US during the 1900s, this century we’ll see the BRIC economies emerge as dominant economic players. Those building investor portfolios simply cannot afford to ignore the BRIC economies.
Locally, the BRIC message is sinking in
We asked the delegates at the PortfolioConstruction Conference — dealer group principals, dealer group researchers, CFPs, research house analysts, asset consultants and super fund executives — for their view of the importance of BRIC economies. Figure 1 (see Money Management October 19, 2006 page 34) shows the results. Only 3 per cent of delegates believe BRIC economies are “irrelevant to how I build portfolios”.
Yet, Dr Don Stammer, a keynote speaker at the PortfolioConstruction Conference on the outlook for the BRIC economies, warned that while the long-term outlook for the BRIC economies is positive, it wouldn’t be plain sailing. “By the nature of their strong growth and rapid change, the BRICs will also be subject to occasional economic crises.”
He noted that profound political changes are to be expected in each of the BRICs, largely driven by the emerging middle classes, and there will be periods of shakeout in individual BRICs.
Stammer also warned that it is a mistake to think of the BRIC economies as one homogenous group. The four economies are very different, he explained.
“Brazil has an emphasis on resources and its middle class is emerging relatively slowly,” he noted.
“Russia on the other hand has an emphasis on energy, with substantial natural resources, accompanied by a falling population. India has an emphasis on technology, and a rising population, while China is focusing on manufacturing and it too has a falling population.”
Implementing BRIC in a portfolio
So, if the high growth BRIC economies are potentially rich sources of investment returns, how is it best to incorporate those opportunities into an investor’s portfolio, particularly in light of the fact that they’re very different economies?
We asked PortfolioConstruction Conference delegates what they thought. Figure 2 (see Money Management October 19, 2006 page 35) shows their responses. There were three main schools of thought among those building investor portfolios.
Around 40 per cent would look to add BRIC economies via an emerging markets allocation — that is, select an emerging markets fund or funds and leave the BRIC decision to the manager/s of the fund/s.
They were not alone. Dr Stephen Wood of Russell Investments, another keynote speaker at the PortfolioConstruction Conference, is a protagonist of BRIC economies being implemented via an emerging markets mandate. He argued that a BRIC-specific mandate “acts as an obstacle to generating risk-adjusted returns” and that investors were better served by adopting “a global emerging market investment mandate that expands [not constrains] the opportunity set available to talented managers”.
Another 40 per cent believe it’s best to take that philosophy one step further and leave the BRIC allocation up to their global equity fund manager(s).
Only 7 per cent said they were currently comfortable adding a specific BRIC allocation to a portfolio.
A case of the right tool for the job?
However, on further analysis, it appeared that many of the 38 per cent of delegates currently leaving the BRIC decision to their global equity manager(s) and the 38 per cent leaving it to their emerging markets manager may be doing so as a default in the absence of tools that allow them to do otherwise.
When we asked delegates how they currently build their international equity portfolios, about one-third were already using regional funds — however, 44 per cent were not, but would like to be able to (see Figure 3 Money Management October 19, 2006 page 35).
A robust methodology for allocating to BRIC (and other regions)
It’s no secret that many of those building investor portfolios are dissatisfied by the fact their research houses have traditionally shied away from providing methodologies and asset allocation models incorporating regional tilts.
So, at this year’s conference, we asked Tim Farrelly, the principal of specialist asset allocation research house farrelly’s, to do just that — to give the 75 per cent of those who would like to, or already are, implementing regional allocations (or even country allocations) in their clients’ portfolios, a robust methodology for the job.
Farrelly made three assumptions:
~ turnover and transaction costs should be kept low (and were assumed to be 0.7 per cent for buying and 0.7 per cent for selling);
~ the process should not rely on signals and market timing; and
~ the process must be capable of being implemented by investment advisers in retail client portfolios.
He divided the world into five regions — the US, Japan, UK, Europe (ex-UK), and the Pacific (ex-Japan) — and used the relevant MSCI Index (US$) to represent the performance of each region over the period of December 1969 to December 2005, the longest period for which MSCI data was available.
However, he was at pains to say, “There is nothing magical about the choice of countries and regions … Advisers can choose their strategies based on regions that make sense to them and have readily accessible avenues for investment”, including, he noted, emerging markets and specific BRIC countries.
And while his analysis was based on indices, “the use of active managers to implement at a country or regional level should enhance returns — if, of course, the managers can produce index outperformance”, he said.
And the four strategies?
~ Equal weights — the portfolio was divided into five equally weighted regions.
~ GDP weights — the portfolio was divided up according to the relative GDP weights of the countries that made up the region.
~ Earnings weighted — the portfolio was divided up according to the value of the earnings generated by each region (as measured by market capitalisation divided by the profits-to-earnings ratio).
~ Smooth earnings weight — the portfolios were divided up according to the smoothed earnings generated by each region.
A three-year rebalance period was used for each strategy initially, however, the impact of different rebalance periods (one, two, three, five and seven years) were assessed subsequently. The best results were achieved by rebalancing every two years, with the three-year rebalance period producing almost as good results.
And the results?
Each of the strategies clearly outperformed the MSCI World Index over the 35-year test period, and in most of the sub periods reviewed. The level of turnover and, therefore, transaction costs were similar in each strategy at 0.05 per cent per annum (that is, annual turnover of around 4 per cent of the portfolio).
The icing on the cake was that the simplest strategy — the equal weights approach — had the most consistent outperformance, beating the MSCI World Index by 1.93 per cent per annum on average after transaction costs.
“The results suggest that there is value from adopting a regional approach to international equities allocation,” Farrelly concluded.
Deirdre Keown is the managing editor of PortfolioConstruction Forum. The presentations referred to in this article were part of the recent 2006 PortfolioConstruction Conference, and each is the subject of a paper that is available at www.PortfolioConstruction.com.au.
