Beauty without the Beast: How to Improve Investment Characteristics of Emerging-Market Exposures

Abstract

Emerging markets, characterized by dynamic economies and capital markets that are less than perfectly correlated to those in developed markets, have become a hot topic. Their lack of correlation with developed markets is of special interest to investors based in or exposed to developed markets, as it helps to diversify their portfolios. However, investors face many challenges when directly investing in emerging markets, including different or reduced regulations, a stronger role for government, exchange-rate risks and, above all, liquidity concerns. Many emerging markets still do not have exchanges as developed and mature as those of developed markets. An alternative approach to direct investment in emerging markets has recently gained popularity: Invest in companies that are incorporated and locally listed in developed markets but that generate a significant share of revenues in emerging markets. As the empirical results of this article show, this approach—which we call “the exposure concept”—provides investors with risk-and-return characteristics significantly tilted in the direction of a direct emerging-market investment. However, since exposure concepts select their constituents among developed market firms, they remain influenced by their home markets, giving them a hybrid character of both worlds.