Robert F. Bruner Robert M. Conroy, CFA Wei Li Elizabeth F. O’Halloran Miguel Palacios Lleras Darden Graduate School of Business Administration University of Virginia Investing in Emerging Markets FOU H N C D R A T A I E O N ES R O R F A I M The Research Foundation of AIMR™ Research Foundation Publications Anomalies and Efficient Portfolio Formation Interest Rate and Currency Swaps: A Tutorial by S.P. Kothari and Jay Shanken by Keith C. Brown, CFA, and Donald J. Smith Benchmarks and Investment Management Interest Rate Modeling and the Risk Premiums in by Laurence B. Siegel Interest Rate Swaps The Closed-End Fund Discount by Robert Brooks, CFA by Elroy Dimson and Carolina Minio-Paluello The International Equity Commitment Common Determinants of Liquidity and Trading by Stephen A. Gorman, CFA by Tarun Chordia, Richard Roll, and Avanidhar Investment Styles, Market Anomalies, and Global Subrahmanyam Stock Selection Company Performance and Measures of by Richard O. Michaud Value Added by Pamela P. Peterson, CFA, and Long-Range Forecasting David R. Peterson by William S. Gray, CFA Controlling Misfit Risk in Multiple-Manager Managed Futures and Their Role in Investment Investment Programs Portfolios by Jeffery V. Bailey, CFA, and David E. Tierney by Don M. Chance, CFA Country Risk in Global Financial Management Options and Futures: A Tutorial by Claude B. Erb, CFA, Campbell R. Harvey, and by Roger G. Clarke Tadas E. Viskanta Real Options and Investment Valuation Country, Sector, and Company Factors in by Don M. Chance, CFA, and Global Equity Portfolios Pamela P. Peterson, CFA by Peter J.B. Hopkins and C. Hayes Miller, CFA Risk Management, Derivatives, and Financial Currency Management: Concepts and Practices Analysis under SFAS No. 133 by Roger G. Clarke and Mark P. Kritzman, CFA by Gary L. Gastineau, Donald J. Smith, and Earnings: Measurement, Disclosure, and the Rebecca Todd, CFA Impact on Equity Valuation by D. Eric Hirst and Patrick E. Hopkins The Role of Monetary Policy in Investment Management Economic Foundations of Capital Market Returns by Gerald R. Jensen, Robert R. Johnson, CFA, by Brian D. Singer, CFA, and and Jeffrey M. Mercer Kevin Terhaar, CFA Emerging Stock Markets: Risk, Return, and Sales-Driven Franchise Value Performance by Martin L. Leibowitz by Christopher B. Barry, John W. Peavy III, Term-Structure Models Using Binomial Trees CFA, and Mauricio Rodriguez by Gerald W. Buetow, Jr., CFA, and Franchise Value and the Price/Earnings Ratio James Sochacki by Martin L. Leibowitz and Stanley Kogelman Time Diversification Revisited The Franchise Value Approach to the Leveraged by William Reichenstein, CFA, and Company Dovalee Dorsett by Martin L. Leibowitz The Welfare Effects of Soft Dollar Brokerage: Global Asset Management and Performance Law and Ecomonics Attribution by Stephen M. Horan, CFA, and by Denis S. Karnosky and Brian D. Singer, CFA D. Bruce Johnsen Investing in Emerging Markets To obtain the AIMR Product Catalog, contact: AIMR, P.O. Box 3668, Charlottesville, Virginia 22903, U.S.A. Phone 434-951-5499; Fax 434-951-5262; E-mail [email protected] or visit AIMR’s World Wide Website at www.aimr.org to view the AIMR publications list. The Research Foundation of The Association for Investment Management and Research™, the Research Foundation of AIMR™, and the Research Foundation logo are trademarks owned by the Research Foundation of the Association for Investment Management and Research. CFA®, Chartered Financial Analyst®, AIMR-PPS ®, and GIPS ® are just a few of the trademarks owned by the Association for Investment Management and Research. To view a list of the Association for Investment Management and Research’s trademarks and a Guide for the Use of AIMR’s Marks, please visit our website at www.aimr.org. © 2003 The Research Foundation of the Association for Investment Management and Research All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the copyright holder. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. ISBN 0-943205-64-6 Printed in the United States of America August 12, 2003 Editorial Staff Roger Mitchell Book Editor Rebecca L. Bowman Jaynee M. Dudley Assistant Editor Production Manager Kelly T. Bruton/Lois A. Carrier Kara H. Morris Production and Composition Online Production Mission The Research Foundation’s mission is to encourage education for investment practitioners worldwide and to fund, publish, and distribute relevant research. Biographies Robert F. Bruner is Distinguished Professor of Business Administration and executive director of the Batten Institute at the Darden Graduate School of Business Administration, University of Virginia. He has written about emerging markets, mergers and acquisitions, corporate finance, and corporate transformation. Robert M. Conroy, CFA, is Paul Tudor Jones II Research Professor of Business Administration at the Darden Graduate School of Business Administration, University of Virginia. He has published articles and case studies on valuation, derivatives, and the microstructure of capital markets. Much of Professor Conroy’s recent research has focused on Japanese financial markets. Wei Li is associate professor of business administration at the Darden Graduate School of Business Administration, University of Virginia. His research and publications focus on public finance, taxation, industrial organization, international economics, the Chinese economy and economic reform in China, and emerging markets finance. Elizabeth F. O’Halloran is director of intellectual capital at the Batten Institute, University of Virginia, where she leads the development of new knowledge supported by the Institute. Her recent projects have focused on emerging markets, knowledge transfer, cross-border foundations of entre- preneurship, and corporate innovation. Miguel Palacios Lleras is a fellow at the Batten Institute, University of Virginia. His research has focused on the design of new financial instruments, liquidity and control premiums, assessment of real options in the presence of uncertainty, and human capital finance. He is the author of Investing in Human Capital and other related articles. Contents Foreword . viii Preface . x Chapter 1. Introduction . 1 Chapter 2. Characteristics of Emerging Markets . 6 Chapter 3. Diversification, Return, and Volatility . 33 Chapter 4. Efficiency in Emerging Markets . 39 Chapter 5. Market Integration and Country versus Sector Factors . 48 Chapter 6. Valuation in Emerging Markets . 71 Chapter 7. Conclusion . 88 Appendix A. Estimating the Total Risk Attributed to the Overall Market Movements. 91 Appendix B. Country versus Industry Regression Model . 93 References . 97 Foreword In May 2002, the Research Foundation of the Association for Investment Management and ResearchTM, in partnership with the Batten Institute at the Darden Graduate School of Business Administration of the University of Virginia and the prestigious finance journal Emerging Markets Review, cosponsored a two-and-a-half-day conference on “Valuation in Emerging Markets.” This event brought together leading academics and practitioners from around the world to present research and to exchange ideas, resulting in a discourse that leveraged both the rigor of academia and the practical experience and insights of leading investment practitioners. The Research Foundation recognized the importance of capturing and preserving this wealth of knowledge and thus enthusiastically encouraged the development of this Research Foundation monograph. Robert F. Bruner, Robert M. Conroy, CFA, Wei Li, Elizabeth F. O’Hallo- ran, and Miguel Palacios Lleras have produced an outstanding document that extends far beyond a summary of the conference’s papers and presentations. They have arranged the contents of the conference into a cohesive collection of chapters, adding where necessary supplementary data and information that was not explicitly presented or discussed by the conference’s participants. Moreover, the authors have brought their own considerable expertise to bear on the subject, resulting in an even richer collection of knowledge filtered through a prism that focuses it on the very real challenges faced every day by investors in emerging markets. For example, they describe the essential features that distinguish emerg- ing markets from developed markets. They provide a statistical summary of the return and risk attributes of emerging markets. They test the efficiency of emerging markets. They evaluate the degree of integration among emerging markets. And finally, they provide an extensive review of valuation methods applied to emerging market securities. Their analysis provides valuable insights about appropriate allocation to emerging markets within broad portfolios, the choice of active or passive management, the relative importance of country and sector stratification, the optimal currency exposure, and the efficacy of fundamental and quantitative analysis. This monograph is clearly an invaluable resource for those who invest in emerging markets, yet it serves a more important purpose.