A comparison of the risk and return characteristics of developed and emerging stock markets.

Kohers, Gerald ; Kohers, Ninon ; Kohers, Theodor 等

ABSTRACT

Finance theory suggests that the higher volatility typically associated with emerging stock market returns translates into higher expected returns in those markets. This paper compares the risk and return profile of emerging and developed stock markets over the period from 1994 through 2001. Specifically, this study investigates, from a U.S. investor's point of view, whether a measurable difference in risk characteristics exists between the two markets and whether the realized rates of return in these two types of markets reflect these risk characteristics. The results show that the risk associated with emerging markets, as measured by the volatility of returns, is notably higher than the risk in developed markets in most periods. However, the returns in emerging markets have been notably lower than those in developed markets for most of the time frames examined. The findings suggest that risk-averse investors seeking higher returns in volatile emerging markets have not been well-compensated for assuming the higher risk associated with these markets.

INTRODUCTION

The literature makes a distinction between developed and emerging stock markets based on their differing characteristics. The world's developed stock markets are generally assumed to be more liquid and efficient compared to their counterparts in emerging countries. Finance theory suggests that the higher volatility typically associated with emerging stock market returns translates into higher expected returns in those markets. While many stock markets underwent considerable evolution during the last decade, emerging markets, in particular, grew exponentionally in terms of trading volume, number of listed companies, and market capitalization (Goetzmann & Jorion, 1999). In recent years, attractive prospects in these markets have renewed the interest of global investors (Domowitz et al., 1997; Richards, 1996; Erb et al., 1997; Bekaert et al., 1997). Although there is some evidence to suggest that many emerging markets are becoming more integrated into the global capital market (Bekaert & Harvey, 1995), overall, these markets still differ from developed markets in their high liquidity risk and limited availability of high quality, large capitalization shares.

The literature provides plenty of evidence suggesting the existence of higher volatility and price changes in emerging stock markets (Salomons & Grootveld, 2003; Appiah-Kusi & Menyah, 2003; Harvey et al., 2000; Kawakatsu & Morey, 1999; Bekaert et al., 1998; Bekaert & Harvey, 1997; De Santis & Imrohoroglu, 1997; Bekaert et al., 1997; Schaller & Van Norden, 1997). Also, compared to developed markets, common characteristics of emerging markets include a high degree of country risk (i.e., political risk, economic risk, and financial risk), currency devaluations, failed economic plans, financial shocks, and capital market reforms. Thus, the higher degree of risk typically associated with emerging markets suggests a higher expected rate of return in these markets. However, some researchers (Harvey, 1995; Bekaert, 1995) suggest the opposite to be true. Therefore, the main motivation for this research is to investigate (a) whether emerging market returns are exposed to more volatility compared to those of their more developed counterparts, (b) how the realized rates of return in the two types of markets compare to each other, (c) whether there exists a measurable difference in risk characteristics between the two types of markets, and (d) how consistent these results are over the period from 1994 through the end of 2001. The year 1994 was selected as a starting point for the comparison since that is the first year where the returns for a sufficiently large number of emerging market countries was reported with any consistency.

The remainder of this paper is organized as follows: Section II discusses the data and methodology, which is followed by the findings, which are discussed in Section III. The paper concludes with a conclusion in Section IV.

DATA AND METHODOLOGY

This research relies on the weekly national stock indices of the developed and emerging markets, as reported by Morgan Stanley Capital International (MSCI). The company categorizes equity markets by a number of factors such as gross domestic product per capita, local government regulations, perceived investment risk, foreign ownership limits and capital controls.

The MSCI Emerging Markets Index measures the equity market performance in the global emerging markets. As of 2001, this index consists of the following 26 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey, and Venezuela.

As of 2001, the MSCI developed equity markets are made up of the national stock indices of the following 23 countries: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. MSCI also reports a World Index, which is a free float-adjusted market capitalization index designed to measure market equity performance for the above-mentioned 23 developed markets.

The combined market capitalization of the companies that comprise any of these indices represents approximately 60 percent of the aggregate market value of the various national stock exchanges. Since these national indices are constructed on the basis of the same design principles and are adjusted by the same formulas, they are fully comparable with one another. The above mentioned indices, representing market-weighted price averages without dividends reinvested, were retrieved from Morgan Stanley Capital International (MSCI). The company reports Thursday's closing prices as the weekly prices. Other financial services such as Standard & Poor's and Value Line, among others, also report "during-the-week" observations for their weekly data. The MSCI indices are considered performance measurement benchmarks for global stock markets and are accepted standards used by global portfolio managers. Each one of the country stock indices is composed of stocks that broadly represent the stock composition of their respective countries.

The mean annual geometric returns are calculated as follows:

[GR.sub.j] = (1 + [R.sub.1]) (1 + [R.sub.2]) (1 + [R.sub.3]) ... (1 + [R.sub.52]) - 1 (1)

where [R.sub.1] is the weekly return (for week # 1) for country j after conversion from the local currency into the U.S. dollar.

A country's overall risk score is based on the rating of the Heritage Foundation's Index of Economic Freedom. This overall risk score is a function of a country's trade policy, fiscal burden, government intervention, monetary policy, foreign investment, banking and finance, wages and prices, property rights, regulations, and the degree to which a black market exists. The scores can range from 1 (best) to 5 (worst). In recent years, the scores for countries with the best rating were around 1.5; countries with the worst risk score rated 5.

RESULTS

Table 1 reports the returns and risk, the latter measured in standard deviation in the rates of return, for the equally-weighted 23 developed markets, the 14 equally-weighted emerging markets, and the value-weighted MSCI World Index by selected time periods over the 1994-2001 time span and by individual years. With the exception of two of the seven time periods examined, the annual returns of the developed markets were higher compared to those for emerging markets. The exception took place for the periods 1998-2001 and 1999-2001, during which emerging markets' returns exceeded those for developed markets. In terms of variations in returns, however, in all cases, the standard deviation of the returns for developed markets were lower compared to those for emerging markets. The results for the value-weighted MSCI World Index, where the returns on the larger markets are more heavily weighted, largely mirror those of the equally-weighted developed markets. Thus, while the degree of risk was consistently higher in emerging markets, with the exception of the 1998-2001 and the 1999-2001 periods, the realized rates of return in developed markets exceeded those found in emerging markets. In other words, in most years examined, investors in emerging markets do not appear to have been properly compensated for their exposure to more risk.

The return-risk results by individual years confirm the above discussed findings over various time spans. Again, while the risk in emerging markets, measured by the standard deviation in the rates of return, was consistently higher compared to developed markets, in only a few cases (that is, 1999 and 2001) did that translate into higher realized rates of return. Thus, taking risk into account, developed markets' investors fared better compared to their counterparts in emerging markets.

Table 1 also shows the overall risk score for developed and emerging markets. A country's overall score takes into account that country's trade policy, fiscal burden, government intervention, monetary policy, foreign investment, banking and finance, wages and prices, property rights, regulations, and the degree to which a black market exists. Each country's score is averaged over the 1994-2001 period. To arrive at the overall score for developed markets, each of the 23 developed-market-countries' average score is added up and then the total is averaged. The same procedure was used to calculate the overall risk score for the 14 emerging market countries. The results indicate that developed markets are clearly less risky compared to emerging markets (risk scores of 2.09 versus 2.82) and there is less variation in these risk scores among developed market countries compared to emerging market countries (i.e., standard deviation of 0.34 versus 0.51).

Table 2 shows the return and risk characteristics by individual developed countries, which are ranked in the table by recent market capitalization values, over three time spans, that is, 1994-2001, 1997-2001, and 2000-2001. For the overall period (1994-2001), 18 of the 23 developed market countries generated positive returns, while five were negative (i.e., Japan, Hong Kong, Singapore, New Zealand, and Austria). The more recent time span (1997-2001) saw a deterioration in returns with two more countries (i.e., Australia and Norway) joining the previously mentioned five countries with negative returns. Finally, the most recent 2-year period examined (2000-2001) shows every single one of the 23 developed market countries with negative returns. Also, it is of interest to note that for the vast majority of countries, the more recent time periods showed elevated risk levels. In other words, on average, the standard deviation of the rates of return for the period 1997-2001 is higher compared to the corresponding standard deviations for the 1994-2001 period, and the standard deviations for the 2000-2001 period tend to be higher compared to those over the 1997-2001 time frame.

Table 3 reports statistics comparable to those shown in Table 2 except the information pertains to emerging market countries. For the 1994-2001 period, of the 12 countries for which returns could be calculated, seven generated positive returns, while for five, the returns were negative. Over the more recent time span 1997-2001, of the total of 14 reporting emerging markets, eight generated negative returns and six were positive. As was true for developed market countries, every single one of the 14 emerging market countries' returns for the most recent period 2000-2001 were negative.

In terms of risk, while the standard deviation of most of the emerging market countries' rates of return tended to be higher compared to those found in developed market countries, unlike the latter, there was no tendency for the standard deviations of the rates of return in emerging market countries to have increased in the more recent time spans.

The results reported in the tables are graphically expressed in Exhibit 1, which shows the risk-return patterns of developed and emerging stock markets by individual years and by the overall period 1994-2001. One notices that, with the exception of the years 1999 and 2001, the mean annual returns for developed stock markets exceed those of emerging stock markets. Also, the exhibit clearly reveals a higher degree of risk (measured by the standard deviation around the mean returns) for emerging stock markets in every single year examined.

CONCLUSION

This paper compares the risk and return profile of emerging and developed stock markets over the period from 1994 through 2001. Specifically, this study investigates, from a U.S. investor's point of view, whether a measurable difference in risk characteristics exists between the two markets and whether the realized rates of return in these two types of markets reflect these risk characteristics. In addition, we examine the consistency of these risk/return relationships for emerging and developed markets over time. The results show that the risk associated with emerging markets, as measured by the volatility of returns, is notably higher than the risk in developed markets in most periods. However, the returns in emerging markets have been notably lower than those in developed markets for most of the time frames examined. The findings suggest that risk-averse investors seeking higher returns in volatile emerging markets have not been well-compensated for assuming the higher risk associated with these markets.

REFERENCES

Appiah-Kusi, J. & K. Menyah. (2003). Return predictability in African stock markets, Review of Financial Economics, 12(3), 247-270.

Bekaert, G. (1995). Market integration and investment barriers in emerging equity markets, World Bank Economic Review, 9(1), 75-107.

Bekaert, G & C. R. Harvey. (1997). Emerging equity market volatility, Journal of Financial Economics, 43(1), 29-77.

Bekaert, G, C. B. Erb, C. R. Harvey & T. E. Viskanta. (1998). Distributional characteristics of emerging market returns and asset allocation, Journal of Portfolio Management, 24(2), 101-116.

Bekaert, G, C. B. Erb, C. R. Harvey & T. E. Viskanta. (1997). What matters for emerging equity market investments, Emerging Markets Quarterly, 1(1), 17-46.

De Santis, G. & S. Imrohoroglu. (1997). Stock returns and volatility in emerging financial markets, Journal of International Money and Finance, 16(4), 561-579.

Domowitz, I, J. Glen & A. Madhavan. (1997). Market segmentation and stock prices: Evidence from an emerging market, Journal of Finance, 52(3), 1059-1085.

Erb, C. B., C. R. Harvey & T. E. Viskanta. (1997). The making of an emerging market, Emerging Markets Quarterly, 1(1), 14-19.

Goetzmann, W. & P. Jorion. (1999). Re-emerging markets, Journal of Financial and Quantitative Analysis, 34(1), 1-32.

Harvey, C. R. (1995). Predictable risk and returns in emerging markets, Review of Financial Studies, 8, 773-816.

Harvey, C. R., K. E. Travers & M. J. Costa. (2000). Forecasting emerging market returns using neural networks, Emerging Markets Quarterly, Summer, 1-12.

Kawakatsu, H. & M. R. Morey. (1999). An empirical examination of financial liberalization and the efficiency of emerging market stock prices, Journal of Financial Research, 22( 4), Winter, 385-411.

Richard, A. J. (1996). Volatility and predictability in national stock markets: How do emerging and mature markets differ? International Monetary Fund, Staff Papers, 43(3), 461-501.

Salomons, R. & H. Grootveld. (2003). The equity risk premium: Emerging vs. developed markets, Emerging Markets Review, 4(2), June, 121-144.

Schaller, H. & S. Van Norden. (1997). Regime-switching in stock market returns, Applied Financial Economics, 7(2), 177-191.

Gerald Kohers, Sam Houston State University

Ninon Kohers, University of South Florida

Theodor Kohers, Mississippi State University

Table 1: World Markets Return and Risk Characteristics Based on
Conversions into U.S. Dollars January 1994-December 2001

 Developed Markets: Emerging Markets:

 Geometric Mean Std. Geometric Mean Std.
 Annual Return: Dev.: Annual Return: Dev.:

Period Annual Averages:

1994-2001 .08068 * .02948 .00658 (#) .05029
1995-2001 .08646 * .03012 .01090 (#) .05052
1996-2001 .07653 .03149 .02853 .05853
1997-2001 .06065 .03437 .02112 .06285
1998-2001 .04668 .03595 .05119 .06416
1999-2001 -.01835 * .03392 .09289 .05665
2000-2001 -.16670 .0385 -.20424 .05675

Annual Averages by Year:

2001 -.18111 .03677 -.13558 .06001
2000 -.15228 .03494 -.27290 .05349
1999 .27834 .03006 .68716 .05647
1998 .24176 .04204 -.07392 .08670
1997 .11655 .02802 -.09915 .05759
1996 .15591 .01709 .06559 .03586
1995 .14602 .02192 -.09469 (#) .04344
1994 .04023 .02499 -.02387 (#) .04868

Country Risk Score: ([degrees])

1994 - 2001: 2.09 0.34 2.82 0.51

 MSCI World Index:

 Geometric Mean Std.
 Annual Return: Dev.:

Period Annual Averages:

1994-2001 .07839 .02048
1995-2001 .08482 .02160
1996-2001 .06822 .02335
1997-2001 .05782 .02568
1998-2001 .04566 .02762
1999-2001 -.02716 .02838
2000-2001 -.15876 .03288

Annual Averages by Year:

2001 -.17856 .02698
2000 -.13895 .03878
1999 .23602 .01937
1998 .26412 .02534
1997 .10647 .01790
1996 .12022 .01170
1995 .18442 .01112
1994 .03341 .01265

Country Risk Score: ([degrees])

1994 - 2001:

(#) Averages exclude 1994 and 1995 returns for China and South Africa,
which were not reported.

([degrees]) A country's average overall risk score was generated based
on information from the Heritage Foundation's Index of Economic Freedom.

Table 2: Developed Markets Return and Risk Characteristics by Country
Based on Conversions into U.S. Dollars

 Average 1994-2001: Average 1997-2001:

 Geometric Std. Geometric Std.
 Mean Deviat.: Mean Deviat.:
 Annual Return: Annual Return:

U.S. .13734 .02347 .10574 .02883
Japan -.01499 .02886 -.03420 .03415
U.K. .06328 .02126 .03652 .02433
Germany .07448 .02753 .06318 .03390
France .09281 .02593 .10364 .03034
Australia .02335 .02542 -.01017 .02719
Switzerland .10769 .02435 .08459 .02762
Netherlands .09456 .02658 .04236 .03370
Italy .09117 .03249 .10591 .03252
Canada .09531 .02606 .07893 .03156
Spain .12670 .03032 .09398 .03462
Hong Kong -.00057 .03957 -.03323 .04420
Sweden .16700 .03651 .10610 .04365
Belgium .07823 .02433 .05743 .02924
Finland .38586 .04822 .46959 .05739
Denmark .09517 .02329 .08106 .02700
Singapore -.00160 .03351 -.00531 .04068
New Zealand -.03498 .03263 -.12777 .03679
Greece .12367 .04111 .17646 .05045
Portugal .07471 .02730 .04583 .03282
Norway .04616 .02778 -.02113 .03153
Austria -.05175 .02632 -.05859 .02878
Ireland .08200 .02516 .03408 .02909

 Average 2000-2001:

 Geometric Std.
 Mean Deviat.
 Annual Return:

U.S. -.12899 .02911
Japan -.29891 .03070
U.K. -.14440 .02668
Germany -.20559 .03925
France -.14654 .03420
Australia -.06755 .02734
Switzerland -.09073 .02756
Netherlands -.14980 .03032
Italy -.15817 .03468
Canada -.08885 .03457
Spain -.14813 .03757
Hong Kong -.19375 .03781
Sweden -.26075 .05179
Belgium -.16352 .03583
Finland -.27849 .07583
Denmark -.07427 .02942
Singapore -.27603 .03683
New Zealand -.15593 .03751
Greece -.33193 .04662
Portugal -.18445 .03115
Norway -.08530 .02795
Austria -.10129 .03015
Ireland -.10071 .03176

Table 3: Emerging Markets Return and Risk Characteristics by
Country Based on Conversions into U.S. Dollars

 Average 1994-2001:

 Geometric Std.
 Mean Deviation:
 Annual Return

Taiwan .00259 .04169
China n/a n/a
South Africa n/a n/a
Brazil .09370 .05767
Korea .17719 .05777
India -.00107 .03846
Malaysia -.01738 .04859
Mexico .04419 .05266
Chile .01040 .03210
Argentina -.03339 .05417
Israel .05926 .03819
Philippines -.12030 .04276
Thailand -.13687 .05620
Turkey .21035 .08321

 Average 1997-2001:

 Geometric Std.
 Mean Deviat:
 Annual Return:

Taiwan -.06381 .04803
China -.23023 .12775
South Africa .05874 .07756
Brazil -.00783 .06019
Korea .32359 .07432
India .05137 .04121
Malaysia -.03777 .05945
Mexico .17747 .05231
Chile -.01999 .03219
Argentina -.05512 .05794
Israel .12930 .04221
Philippines -.19098 .04930
Thailand -.10843 .06854
Turkey .38688 .08889

 Average 2000-2001:

 Geometric Std.
 Mean Deviat.:
 Annual Return:

Taiwan -.27441 .05691
China -.28943 .10282
South Africa -.20069 .06863
Brazil -.21172 .04425
Korea -.17798 .05504
India -.21833 .04740
Malaysia -.16685 .03472
Mexico -.14980 .03032
Chile -.08029 .02651
Argentina -.24466 .06370
Israel -.03993 .05458
Philippines -.28921 .04454
Thailand -.17923 .04897
Turkey -.46290 .09412