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The EMM Global Emerging Markets Country Allocation Model is a "relative
value" based tool that recommends country allocations across emerging markets.
Because most active portfolio risk in a well-diversified emerging markets' portfolio
comes from country allocation, we created a tool which addresses country allocation
in a systematic and rigorous way. The "Model" calculates expected
returns for individual equity markets, measures the trade-off between these
expected returns and risk, relative to a benchmark, and suggests country allocations.
The model uses stock market and macro-economic data to derive
expected returns for individual markets. Cash flows, earnings,
dividends and earnings adjusted for accounting differences,
are discounted in order to derive estimates of "fair
value". Internal rate of return calculations, earnings
revisions data, interest and exchange rates are utilized as
well. Market correlations and historic volatility are also
used as inputs.
Suggested country allocations are influence by the "strength"
of the model signals (how far are current prices away from
their "fair value") and the "clarity"
of the signals (how well has the particular input successfully
helped in forecasting). Together the strength and clarity
of the signals determine how much a market should be over
or under-weighted in comparison with a benchmark.
The model has been a part of Emerging Markets Management's investment approach
since the Firm's inception in 1987. Although continually refined and upgraded,
the model's "relative value" orientation has remained unchanged. A
model such as ours is extremely helpful in processing and evaluating a huge
variety of relevant data simultaneously and avoids a narrow focus on one or
two factors that may temporarily dominate market sentiment. It makes explicit
trade-offs between return and risk, includes long-term factors, screens variables
that contribute to "noise" rather than reality, and attempts to optimize
diversification.
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The model's foundation is built on the calculation and
comparison of expected equity returns for individual emerging markets.
In our process, we treat each individual equity market as a single stock
with all the relevant characteristics of that market. We calculate expected
returns for each market by weighting a collection of eight separate models
of expected return, partly based on each model's individual historical
predictive power. The models derive returns using different measurements
of corporate cash flows but, at their core, they estimate equity returns
as coming from future
growth, current
yield and market
multiple reversion.
All expected returns are calculated in real terms from
a U.S. investor's perspective (by using purchasing power parity-based
currency forecasts). Once expected returns are calculated, adjustments
are made for stock market correlations, predictability and benchmark differences.
Finally, the model suggests country weightings. The allocation model is
run daily and processes daily price, interest rate and exchange rate information
on about twenty emerging economies. It is recalibrated on a monthly basis.
Country allocation model research is conducted internally
using macroeconomic data (GNP per capita, inflation, interest rates and
exchange rates) as well as stock market data (market prices and capitalization,
expected corporate profit forecasts, earnings revision data and various
measures of corporate cash flow). Research tools include econometric estimation
software. Data sources include local country government sources, brokers,
quotation service vendors, Morgan Stanley Capital International, Standard
and Poors and International Financial Statistics (International Monetary
Fund) data.
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