Is Decoupling Done?

• By Heather Bell
• On 3:00 am EST, Thursday January 8, 2009

It was one of the most tumultuous years in history. Largely as a result of a spreading credit crisis across the globe, investors were hit hard by deteriorating market conditions in 2008.

By year's end, the S&P 500 had a total return of -37%, with the SPDR S&P 500 exchange-traded fund (AMEX:SPY - News) down a similar amount.

But the storm that ravaged the U.S. markets hit other countries even harder—particularly emerging markets. The MSCI EAFE Index, the most widely tracked benchmark for developed international markets, was down about 45% in 2008.

At the same time, most broad emerging markets ETFs fell in the vicinity of 50%. Results, however, did vary substantially based on region and country.

Performance Overview

The iShares MSCI Emerging Markets Index Fund (NYSEArca: EEM) fell 48.89%, while the Vanguard Emerging Markets Stock ETF (NYSEArca:VWO - News), which tracks the same index from MSCI, dropped 52.48%. (The underlying index for both lost 54.58%.)

EEM is optimized and VWO is a full-replication fund, which is the likely explanation for the significant performance difference.

Meanwhile, the SPDR S&P Emerging Markets ETF (NYSEArca:GMM - News) dropped 51.06%, while the PowerShares FTSE RAFI Emerging Markets ETF (NYSEArca:PXH - News) and WisdomTree Emerging Markets High-Yielding Equities ETF (NYSEArca: DEM) fell 45.28% and 34.56%, respectively.

It should be noted that relative outperformers PXH and DEM are both based on alternatively weighted indexes.

The four BRIC countries—Brazil, Russia, India and China—had been viewed as the powerhouses of the emerging markets, but they seemed to bear the brunt of world events.

The SPDR S&P BRIC 40 (NYSEArca: BIK) lost 55.54%, while the iShares MSCI BRIC Index Fund (NYSEArca: BKF) slipped 57.32%. The Claymore/BNY BRIC (NYSEArca: EEB) did the best of the three funds, down 54.82%.

Russia, which saw quite a bit of its own turmoil in 2008, was perhaps the most distressed of the four markets. The Market Vectors Russia ETF (NYSEArca:RSX - News) fell a rather breathtaking 73.61% during the year. In addition to dragging down the BRIC indexes, it looks like difficulties in Russia may have contributed to the under-performance of Eastern Europe in general. MSCI's EM Eastern Europe Index sank nearly 70% for the year.

(An interesting side note is that although there are currently no funds covering the region as a whole, Barclays Global Investors has filed to add just such an ETF to its iShares lineup.)

India also performed quite poorly, though not as badly as Russia. The exchange-traded note tracking the MSCI India Index, the iPath MSCI India ETN (NYSEArca:INP - News), fell 67.64% in 2008.

Meanwhile, the funds covering China and Brazil did much better, with the iShares FTSE/Xinhua China 25 Index Fund (NYSE Arca:FXI) and SPDR S&P China ETF (NYSEArca: GXC) down 47.77% and 49.63%, respectively. The iShares MSCI Brazil Index Fund (NYSEArca:EWZ - News) fell 54.64%.

A Regional Breakdown

Viewed from a regional perspective, performance varied to a significant extent. Eastern Europe, in particular, was hit very hard, no doubt in part due to Russia's disastrous performance and its rather dramatic problems in 2008, not the least of which was the invasion of Georgia. The SPDR S&P Emerging Europe ETF (NYSEArca:GUR - News) lost 65.66%.

But it's important to note that Russia represents more than half of GUR's portfolio. Four others—Poland, Turkey, the Czech Republic and Hungary—each represent anywhere from 5% to 15% of the fund's holdings.

According to MSCI, South Africa's market dropped around 40%, while Israel fell just about 31%. Meanwhile, the MSCI Frontier Markets Africa Index lost roughly 56%, and the MSCI Emerging & Frontier Markets Index dipped about 46%.

Latin America showed "moderately bad" performance, with iShares S&P Latin America 40 Index Fund (NYSEArca:ILF - News) down 47.38% and the SPDR S&P Emerging Latin America ETF (NYSEArca:GML - News) down nearly 51%. The MSCI Emerging Latin America Index was down 52.78%, but there was a wide degree of variation in performance. While Brazil was down roughly 58%, MSCI's Chile and Colombia indexes were down about 37% and 27%, respectively—the iShares MSCI Chile Investable Market Index Fund (NYSEArca: ECH) was among the best-performing single-country emerging market ETFs, with a decline of 37.64%.

Asia's performance was similarly poor, with the SPDR S&P Emerging Asia ETF (NYSEArca:GMF - News) down 49.58%—keep in mind that the fund's portfolio includes both China (39% of the portfolio) and India (18%). The MSCI Emerging Markets Asia Index dropped roughly 54%.

Frontier Markets In Focus

One could argue that 2008 was the year that investors discovered frontier markets, as ETF providers launched the first exchange-traded products to cover that designation. With none of those funds trading prior than last year, there is no annual data available, but the MSCI Frontier Markets Index fell 55.41% for the year, about the same as the MSCI Emerging Markets Index. The combined emerging and frontier markets index lost 54.44%.

Quarterly data is available on most of the frontier ETFs that launched, however. The S&P 500 was down 21.94% during the fourth quarter, when the worst of the credit crisis hit the markets. By comparison, the MSCI Emerging Markets Index was down 27.94% and the MSCI Frontier Markets Index was down 41.03%—frontier markets had held up relatively well throughout the year in comparison with standard emerging markets, but the fourth quarter revealed that their outperformance was simply the result of a delayed reaction.

Of the frontier funds, the broadly focused Claymore/BNY Mellon Frontier Markets ETF (NYSEArca:FRN - News) fell a little less than 30%. (Note, however, that FRN's largest component is Chile, which is generally considered an emerging market and represents more than a quarter of the portfolio.) Meanwhile, the Market Vectors Africa Index ETF (NYSEArca: AFK) was down about 35% during the quarter, and the Market Vectors GCC Index ETF (NYSEArca:MES - News), which covers the countries of the Gulf Cooperation Council in the Middle East, was down 39%.

What Happened To EM's Diversification Benefits?

One of the big questions lately has been whether this broad-based decline means that the concept of "decoupling" is now null and void. After all, frontier and emerging markets were hit even harder than developed markets.

The appeal of such markets has traditionally been based on their low correlation with the developed world and the diversification that provides for investors' portfolios. It's true that correlations among markets—especially between developed and emerging markets—have been increasing, but the diversification benefit has by no means disappeared.

The important thing to remember is that 2008 by no means represents an average year. The declines seen in global markets were broadly based, and it was the rare asset class that didn't take a severe hit.

"All asset classes basically converged to a correlation of one or pretty close to that. We saw the same thing happen with emerging markets, with commodities, with real estate, with infrastructure," said Amy Schioldager, managing director and head of indexing at Barclays Global Investors.

"There's no asset class that you can really point to and say that, in the last half of 2008, it was a diversifying asset class, because nothing was. Everything was reacting in the same manner and had negative returns," she added.

Alka Banerjee, Standard & Poor's vice president of global equities, believes some investors may not be seeing the full picture.

"One thing that is very clear is that the global markets are very interlinked. There's no such thing as being completely out of the loop," she pointed out.

For example, Banerjee notes that emerging markets are dependent upon developed markets to buy their products. As a result, she notes that developing economies can be directly impacted by economic conditions in developed markets.

In fact, Banerjee says gross domestic product growth is where the real "decoupling" takes place. Even if an emerging market's GDP growth falls from 10% to 5%, it will still be higher than that of developed markets, she notes.

"That's more of a decoupling on a trend line," Banerjee said.

Like Banerjee, Schioldager believes that GDP is important to consider when discussing decoupling, noting that recent IMF projections for emerging markets for 2009 put GDP growth at 3%-4%, while GDP was expected to fall by 1% for developed markets. She says that the IMF has put five-year average GDP growth for emerging markets at 5.1%, but at just 1.9% for the U.S.

So what in particular pushed emerging and frontier markets off the cliff?

Those markets do not exist in a vacuum, point out indexing experts. They might be less linked to developed markets, but a more globalized world makes ripple effects much less avoidable.

"When I look at the first half of the year, there were a lot of inflation worries, the markets were pretty overheated, core inflation numbers had increased, commodity exporters were doing pretty well," Schioldager said of emerging markets.

The second half of 2008 saw the credit crisis hit emerging markets, with central banks moving to cut rates, while the decline of the commodities markets meant commodity importers were performing better than exporters, she adds.

"I think what's interesting about this crisis is that it is developed-market led," Schioldager said, pointing out that the big meltdown in the late 1990s—the Russian default crisis and the Asian currency crisis—had their roots in emerging markets.

Banerjee attributes part of the decline in emerging markets to the flight to safety that resulted from the credit crisis, even though the credit crisis had its origins in developed markets. "Emerging markets are the first thing that people dump, because they see them as more risky," she said.

The result was billions of dollars of institutional global money being pulled out of emerging markets, but she noted other factors that also contributed to the developing markets' distress. Those included the declines in the commodities markets (the Dow Jones-AIG Commodity Index fell nearly 40% in 2008, while the Energy-heavy S&P GSCI index fell even further—more than 46%).

Other factors were the strengthening U.S. dollar and falling demand from developed market customers who tend to buy the things that emerging and frontier markets produce.

As previously noted, the BRIC countries were among some of the hardest hit, while frontier markets seemed to avoid the worst of the downturn until late in the year. This makes sense, as the BRIC countries have long been favorites of emerging market investors, plus their economies are more closely linked to those of developed markets, making them more vulnerable to the effects of the pullout of investor dollars, the decline in commodity prices and other factors.

Frontier markets, on the other hand, were not as affected by the flight to safety that occurred because there simply wasn't as much foreign investment in the markets. Schioldager notes that smaller emerging markets have done better because they were less exposed to the global impact.

The Year To Come

BGI's Schioldager says she remains bullish on emerging markets for 2009.

"The projected growth rates and the secular trends that have been in place in emerging markets still exist," she noted.

Those trends include strong infrastructure development, a growing middle class, continued globalization, and young populations, says Schioldager.

She also notes that emerging markets are generally better-positioned to handle crises than before, with better capital account balances and central banks taking action more quickly; they are also paying down foreign-denominated debt for the most part (Ecuador is one notable exception).

"The basic foundation from which emerging markets sit is still absolutely there, and with valuations being quite cheap, I think EM will do quite well," Schioldager said.

She added that eastern Europe has been oversold and expects continued improvement in China (which has done well in recent weeks) and improvement in Asia in general.

S&P's Banerjee is also striking an optimistic tone.

"I think in the first half of 2009, the general consensus is that it will be tough for all markets in general. And I think that towards the end of the first half, you're going to get a clearer picture of who's emerging better-equipped to deal with this and how they're handling it," she said, adding that what happens with currency and commodity markets will help determine the outcome for emerging markets.

Banerjee believes, in particular, that countries that are not dependent on a single export are more likely to recover quickly.

"Countries that have a strong economic growth pattern—like China, India and Brazil—will pull out of it sooner than others. Because they are large and they have a robust economy, they can withstand these shocks better," she said.

Buzz up!