EM Risk Premium

Emerging Markets Equity: risk premium and its sources Emerging Markets (EM) are an asset class that brings together shares of companies from developing countries. Investors historically expect higher returns from EM in exchange for taking on additional risks not characteristic of developed markets. What is the EM risk premium? The EM risk premium (Equity Risk Premium) is the additional expected return above the risk-free rate and the premium of developed markets. This premium compensates investors for the specific risks of developing economies. Decomposition of the EM premium Risk componentPremiumSourceExamples Political risk+1-2%Instability of governments, expropriation, sanctionsRussia 2022, Venezuela Currency risk+1-2%Devaluations, capital controls, inflationTurkey, Argentina Liquidity+0.5-1%Lower trading volume, wide spreadsFrontier markets Governance risk+0.5-1%Weak protection of minority shareholders, corruptionChina VIE, SOE Regulatory risk+0.5-1%Sudden rule changesChina EdTech 2021 Total premium+3-6%Above DM equity premium Historical Returns: EM vs DM PeriodMSCI EMMSCI WorldDifference 2000-2010+10.5%+0.5%+10.0% 2010-2020+3.5%+10.0%-6.5% 2020-2024+2.0%+11.0%-9.0% Long-term (30 years)8%7%+1% Conclusion: The EM premium is not guaranteed every year. EM can underperform DM for decades. When do EM perform well? Weak dollar — EM assets appreciate in USD, debt burden decreases Growth in commodities — many EM are commodity exporters Global risk-on — capital seeks yield Fed eases policy — rate cuts → flow into EM Growth of China — the largest EM economy supports the others When are EM vulnerable? Strong dollar — capital outflow, debt stress Rising Fed rates — competition for capital Risk-off — flight to quality (US Treasuries, gold) Drop in commodities — hit to exporters Geopolitical shocks — sanctions, wars Dollar Cycle and EM There is a clear inverse relationship between the strength of the dollar and EM returns: Dollar phaseEM performanceReason USD weakeningOutperformanceCapital inflows, commodity growth USD strengtheningUnderperformanceCapital outflows, debt stress CIO strategies for EM allocation ApproachDescriptionEM share Market WeightBy weight in MSCI ACWI12% GDP WeightBy share of global GDP40% TacticalVaries by cycle0-20% Core/SatelliteMinimum in core, active in satellite5-15% Recommendations for CIO Diversify within EM — do not concentrate on a single country Watch the dollar — DXY index as a key indicator Hedging costs — currency hedging is often too expensive Long-term horizon — EM require patience (cycles of 5-10 years) Active vs Passive — there is a place for active management in EM