New Tools in the Toolbox: Economic and Geographic Exposure Indices

By Karl Mergenthaler, CFA and Kinal Patel
karl.c.mergenthaler@jpmorgan.com and kinal.patel@jpmorgan.com

In an increasingly globalized world, investors are searching for better tools to measure their economic exposure to various regions and countries. As many large companies rely on international markets for significant portions of their revenue, it seems clear that their performance will likely be tied to economic growth in foreign markets.

Two major index providers, MSCI and Russell, recently created indices that measure exposure to international markets and regions. These tools may help investors determine how sensitive a given investment manager is to certain markets.

In this article, we will briefly review the global economic landscape. Moreover, we provide an overview of economic and geographic exposure indices. In our view, investors may want to consider incorporating economic exposure indices into their overall performance and risk measurement programs.

Global Economic Growth

The global economy is becoming increasingly complex and integrated. Over the past forty years, emerging markets have gained an increasingly large portion of global economic activity, while the influence of developed markets has declined. In Exhibit 1, we illustrate the proportion of global Gross Domestic Product by region over the past four decades.

Exhibit 1: Global GDP by Region

Source: International Monetary Fund, J.P. Morgan estimates.

As indicated above, 2005 marked a turning point wherein emerging markets surpassed developed markets in terms of percentage of GDP. Over the past few years, emerging markets have continued to capture market share in GDP terms from developed markets.

Companies have similarly seen a shift in their revenue base. Companies are increasingly venturing out from their domestic markets in order to capture more profits. Emerging markets have become a more attractive option especially as rapid advances in technology now allow business to be conducted far more quickly and efficiently. The ability to easily connect with remote locations makes it more feasible for companies to expand past domestic and other traditional developed markets.

Meanwhile, domestic and international equity markets have become more highly correlated. In Exhibit 2, we calculated the rolling two-year correlation of U.S. equities and international developed equities using broad-based indices over the past 30 years.¹

Exhibit 2: U.S. and International Equities Correlation

Source: Bloomberg, MSCI, Russell, J.P. Morgan estimates.

As shown in Exhibit 2, correlations between U.S. and international developed equities have trended positively starting in the mid-1990's.

Despite their growing economic importance, emerging markets represent a relatively small proportion of traditional global equity market capitalization. For instance, the MSCI All Country World Index (ACWI) includes approximately 8,500 stocks from 24 developed and 21 emerging market countries. In this index, emerging market countries account for just 13% of the total. Meanwhile, the Russell Global index includes about 10,000 securities, with emerging markets accounting for about 14% of the total market cap.

Economic and Geographic Exposure Indices

In recent years, MSCI and Russell have developed new indices that attempt to represent the opportunity set of companies with economic exposure to target markets such as emerging markets. These indices present another perspective for fund managers and investors to measure and monitor their exposure to global markets.

In MSCI's methodology, economic exposure is determined primarily by revenue coming from a target region. MSCI analyzes the applicable companies and first classifies them as developed or emerging markets. MSCI then selects the top 300 most highly exposed companies to the target market for inclusion in its index. Over a ten year period, the MSCI World with Emerging Markets Exposure Index has outperformed the MSCI World Index, though it is underperforming the MSCI Emerging Markets Index.

In Russell's methodology, exposure is determined by the weighted product of three factors- economic exposure, market exposure, and market capitalization. Russell entered into a partnership with Revere Data, LLC, a leading industry expert that provides market and revenue data. Revere maintains a database with information from more than 35,000 companies. This data is used to determine which companies are selected for inclusion in the Russell Geographic Exposure Index. Performance for the Geographic Exposure Large Cap index has been in line with the Russell Emerging Market Large Cap index. However, the Geographic Exposure Large Cap index underperformed the US Large Cap index over the past year.

Investor Allocation to Equities

J.P. Morgan's Investment Analytics & Consulting team reviewed the asset allocation of a randomly selected sample of large U.S. corporate and public pension plans. In general, public plans tend to have a higher allocation to equities than corporate plans. Both corporate and public plans are increasing allocations to developed and emerging markets, as well as alternatives such as hedge funds. Although international equity allocations have been increasing over the past decade, there is some evidence of home country bias among our institutional client base.

J.P. Morgan also took a random sample of pensions in the United Kingdom and Continental Europe. Among U.K. pensions, the equity allocation is typically 40-60% of total plan assets. Many clients have hired specific U.K. equity managers. Among European pensions, the equity allocation is typically 30-40% of total plan assets. Many of our European clients have a manager dedicated to equities in their home country.

In our opinion, pension plans and other asset owners may be able to use the new economic and geographic exposure indices in many ways. For example, the guidelines of a plan may preclude investment in emerging markets. In this case, the asset owner may want to use economic exposure benchmarks to gain access to these regions through developed market companies. Also, some institutional investors may want to use economic exposure indices as a secondary check against their stable of managers. In many ways, we believe economic and geographic exposure benchmarks should help investors and asset owners measure and monitor their macro-economic risk profile.

Conclusions

In our view, these new indices and strategies represent another set of tools that may help institutional investors meet their objectives. We believe it is worth the effort to analyze and understand these new indices. Even while investors tend to show a home bias, these new indices are one way to capture a global market while still investing within a comfort zone. As equity markets continue to evolve through advances in technology and globalization, it becomes increasingly important for investors to have access to new markets. We believe that economic and geographic exposure indices are one tool through which this is possible.

Appendix: Economic and Geographic Exposure Indices

¹ Russell 3000 and MSCI EAFE indices were used.