Growing Sector Momentum in Emerging Markets John Capeci, Ph.D. Managing Partner, Arrowstreet Capital, L.P. Marta Campillo, Ph.D. Partner, Arrowstreet Capital, L.P. April 2002Introduction The increasing importance of global sector influences on international equity returns has been well documented. As markets have become increasingly integrated, investors have become more focused on investment opportunities that arise from mispricing among global sectors as opposed to mispricing among markets. By and large, the research into sector influences has been concentrated on developed markets. Over time, however, it is plausible that global sector influences will also provide important investment opportunities in the emerging markets. This note examines the importance of global sectors in emerging markets, focusing specifically on a strategy that has performed quite well in the developed markets, investing on the basis of global sector momentum. Overall the results are very encouraging. Although global sector momentum is currently less effective for forecasting stock returns in the emerging markets than in the developed markets, sector momentum strategies in the emerging markets still appear to add value. Furthermore, the usefulness of global sector momentum for forecasting emerging market stock returns is increasing. Part of the recent success of global sector momentum strategies in emerging markets can be attributed to the technology-media-telecom (TMT) bubble. Even so, the increased effectiveness of global sector momentum for forecasting returns in the emerging markets is evident across a wide range of sectors from the “old economy” as well as the new economy. We believe that the increased effectiveness of global sector momentum is part of a broader trend toward global integration, a trend that naturally pervades the emerging markets later than the developed markets. The Traditional View Events such as the Asia crisis of 1997-1998 regularly remind investors of the importance that regional risks play in emerging equity markets. Exposure to political risk, devaluation risk, and corruption risk, while present to some degree in the developed markets, are much more pronounced in the emerging markets. For this reason, managers have traditionally taken the view that top down macroeconomic influences are relatively more important than global sector influences for determining emerging market stock returns. What Do We Mean By Global Sector Momentum? Momentum investing is based on the idea that stocks which have performed well over some interval in the past will tend to perform well in the future. The tendency for individual stocks to outperform after periods of past outperformance has been well documented in several market settings. In general, the effect seems highly pronounced when momentum is measured over a period of several months to a few years. To understand why momentum investing should prove effective, it is useful to think of momentum as the counterpart to another market inefficiency, namely value. A behavioral explanation for why value investing works over long periods is that investors pay excessively for companies that have exhibited signs of “success”, such as high long term profit growth, or high long term price growth. This overpayment for success often takes the form of high valuation ratios. Value investing works because investors overestimate the extent to which past success can be extrapolated into future success, 1leading to an eventual price correction. The counterpart to this story is that, over some period, investors continue to bid up prices of firms which display past success, thus leading to the pattern of momentum. The same concept which applies for individual stocks applies for aggregate groups of stocks. Global sector momentum is based on the idea that global sectors which have performed well over some interval in the past will tend to perform well in the future. To the extent that investors evaluate securities on a top down basis, we expect them to make behavioral mistakes when valuing groups of stocks similar to those made when valuing individual stocks. In the case of the emerging markets, the concept of global sector momentum has an additional wrinkle. Because the emerging markets comprise a small fraction of any global sector’s market capitalization, the success of a global sector momentum strategy in the emerging markets presumes that price performance in the developed markets spills over into similar sectors of the emerging markets. Since the emerging markets are often considered to be “downstream” of information that first influences the developed markets, the presence of such a spillover effect seems very plausible. The Evidence How strong is the predictive power of sector momentum effect in the emerging markets? Figure 1 plots the statistical significance of 12 month sector momentum in explaining relative emerging markets returns. Here we measure sector momentum by the average monthly return over the prior 12 months of a capitalization weighted sector index. The sector index is produced from Datastream index data, using information from 38 countries and 10 industrial sectors. The returns used to construct the momentum indicator are measured in local currency to distinguish equity momentum from currency momentum. Underlying this graph is a regression model generating historically a sequence of optimal weights for global sector momentum, as produced by Arrowstreet’s emerging markets equity model. The model generates factor weights for a range of predictive factors pertaining to value, momentum, and earnings growth. The regression model relates relative returns among 140 emerging market country/sector baskets to these factors. The model is estimated over the period December 1989 to the month indicated on the graph, and the contribution of sector momentum is measured by its T-statistic in the regression. The graph shows the significance of global sector momentum, as we roll through time, starting in January 1997. Figure 1: Significance of 12 Month Sector Momentum in Forecasting Relative EMK Equity Returns-4.0-2.00.02.04.01997m11997m71998m11998m71999m11999m72000m12000m72001m12001m7MonthT Statistic 2Although the model has always found a positive relationship between global sector momentum and relative emerging market equity returns, the factor adds little to the model prior to the middle of 1999. It is interesting to note