Integrating Emerging Market Equities into a Global Portfolio

© 2007 Northern Trust Corporation northerntrust.com© 2007 Northern Trust Corporation northerntrust.com

Integrating Emerging Market Equities into a Global PortfolioSeptember 10, 2007

Steven A. SchoenfeldChief Investment Officer – Global Quantitative Management

2 The Northern Experience

A C C E S S . E X P E R T I S E . S E R V I C E .

Presentation Overview

I. The Dynamic Global Investment Landscape

A. Globalization and the Imperative to Evolve Asset Allocation

B. Proliferation of Investment Choices

II. Emerging Markets – An Evolving Asset Class

III. Implementing an Emerging Markets Strategy – Index “versus” Active management

IV. Conclusions


I. The Dynamic Global Investment Landscape



Investing in a Dynamic Investment Landscape

Relative size of the US market has shrunk, despite a robust American economy and stock market

Dollar has steadily weakened; further increasing importance of international diversification

Sustained rise of Emerging Market equities and developing economies

Growing acceptance of “Alternatives”… (despite much confusion about what they are!)

Increased availability of index-based exposure for most investable asset classes

Ability to separate Beta and Alpha, and the portfolio efficiency of doing so

The World has changed dramatically since the early 1990s…



0%

20%

40%

60%

80%

100%

U.S. Total Market - @ $16 Trillion

Globalization and the Imperative to Evolve Asset Allocation

How the world of equities has changed…

U.S. Equities – @ $16 Trillion Total Market Cap From incomplete approach to total market exposure

Large / Mid / Small Capitalization Exposure

Seamless Style Exposure

71%

20%

9%

Source: Morningstar, 12/30/06

Large Cap(S&P 500, Russell 1000, etc)

Mid Cap(S&P 400, Russell 1000, etc)

Small Cap(S&P 600, Russell 2000, DJW 5000)



How the world of equities has changed…

Source: NTGI, S&P, MSCI, FTSE; January 2007

Non-US Market Capitalization by Region

Samsung CNOOCHyundai TEVAEmbraer HaierCEMEX SABMiller

Bombardier Research in Motion (RIM)TD Bank Nortel

Developed Non-North America

70%

Canada5%

Small Cap12%

Emerging Markets

13%

Other30%

Isuzu SNECMA Burberry Celanese


International Equities– @ $19 Trillion Total Market Cap From developed markets only, (and the dominance of ‘EAFE’) to developed plus

emerging markets, to ‘total international’

Still not ‘complete’ or ‘seamless’

Benefits of a ‘total international approach’




Why International exposure is important…

World GDP

United States20%

Developed World ex -

US32%

Emerging Markets

48%

Population

Emerging Markets

84%

United States

5%

Developed World ex -

US11%

Demographics – major share of the world population outside the U.S.

Share of World GDP and Economic Growth The United States (in PPP terms) only represents 20% of World GDP

Source: NTGI, World Bank, IMF, July 2006



B. Proliferation of Investment Choices– Asset Classes and Strategies

US Equities

International

Equities

Equities – Expansion of the Traditional Framework

Then NowLarge Cap (S&P 500) Large Cap

Small Cap (Russell 2000) Mid Cap

Small Cap DJW 5000

Russell 2000

Then Now

Developed Large / Mid Developed Large / Mid

(MSCI EAFE) Emerging Markets

International Small Cap MSCI ACWI x US

FTSE Global All Cap

S&P Global BMI

DJW Global

Russell Global


II. Emerging Markets – An Evolving Asset Class



Structural reforms in emerging markets have provided a more stable investing environment

Foreign exchange-denominated debt reduction from 90% of GDP to 10% (EM aggregate)

Improved fiscal balances to a slight deficit of 0.3% of GDP last year for all emerging markets

Greater transparency at both the government and corporate level as emerging market countries move to US GAAP or European IAC standards

Big improvements in “Big Emerging Markets”

Reduced systemic risk

Sovereign ratings upgrades, e.g. : Mexico, Brazil, Korea, China, India

Minimized “contagion effect”

Diversification benefit of Emerging Markets remain, despite higher correlations with developed markets

Since the late 1990s, there have been substantial micro and macroeconomic advances…

A Maturing Asset Class



Relative P/E

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06

MSCI EMF +12m PER / MSCI World +12m PER

Emerging Markets P/E Relative to Developed World P/E

Source: Credit Suisse, MSCI, June 2006



Monthly Cumulative Returns

0%

200%

400%

600%

800%

1000%

1200%

1400%

1600%

1800%

Jan-

88

Jan-

89

Jan-

90

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

MSCI Emerging Markets

S&P 500

MSCI EAFE

Why Emerging Markets? – Long-Term Performance

The Emerging Markets index (MSCI) has greatly outperformed: Developed International markets (as measured by MSCI EAFE Index)

US equities (as measured by the S&P 500)

From December 2001 to June 2007, Emerging Markets rose by 234% S&P 500 rose 31%

EAFE rose 96%

Source: NTGI, MSCI, Standard & Poor’s, June 2007


III. Implementing an Emerging Market Strategy Index “versus” Active management



Why Use Index Funds in Less Efficient Asset Classes?

“Being There” – Ensure allocation consistent with strategic policy

“Being There” – Efficient way to achieve asset and style diversification

“Allocation explains 95.6% of variability” (Brinson, Beebower & Hood, 1995) “Including style, allocation explains 95% of variability “ (Sharpe, 1988)

Cost effective (at least 1% cheaper than active emerging markets strategies)

Commissions Bid/ask spreads Management fees Custody costs Securities lending

Difficult to consistently select outperforming managers “Arithmetic of Active Management” (Sharpe, 1991) Survivorship bias



Risk Return CharacterisiticsFive Years ending 06/30/06

0%

5%

10%

15%

20%

25%

15% 17% 19% 21% 23% 25% 27% 29%

Annualized Risk

An

nu

aliz

ed R

etu

rn

S&P 500

MSCI EM

Russell 2000MSCI EAFE

Median EM Active Manager

Risk Return Characteristics

Source: NTGI, Callan Associates

The benefit of EM Equity Beta



Transaction costs and high turnover are deadweight costs for active managers to overcome

Commissions Bid-ask spread Market impact

Benchmark methodology improvement Fewer outlier opportunities outside the benchmark as

indexes have evolved to reflect changes in asset class

Growth of assets under management Propensity toward more benchmark ‘sensitivity’

Capacity Constraints Managers protect existing performance by closing funds

to additional investors Increasingly difficult and costly to invest new assets

without market impact

Improved data/information quality Information advantage has eroded

Challenges for Active Emerging Market Managers

Why pay 100 bps or more in management fees when indexing can provide exposure at a much lower cost?



Higher dispersion of returns = diminished alpha opportunity

Dispersion of returns much higher than domestic equities and developed international large cap

Survivorship bias Landscape and drivers of performance have changed significantly

in the last ten years

Many new managers in asset class, as well as global and developed-international “dabblers”

Precision with manager performance universes is warranted Relevance of averages and median ranking versus asset

weighted universes



How is the aggregate of Active EM assets performing?

Source: S&P Index Versus Active, MSCI; December 31, 2006

Average Emerging Market Performance (Asset Weighted) vs. Indexes

0

10

20

30

40

S&P/IFCI Composite 17.72 35.11 32.77 28.71

MSCI EM 17.64 32.58 30.52 26.59

Emerging Markets Active Managers 16.8 30.75 30.19 27.37

4Q 2006 1 Year 3 Year 5 Year



What Matters Most?

Efficient Beta – How do you achieve it?

Index “vs.” Active in Emerging Markets Is there a role for both?

Do the management fees for active management erode the beta – and alpha? Are you paying too much for beta exposure?

Does the limited capacity of top managers diminish the value of historical peer universes?

The importance of “being there” – Allocation

Factors to consider when incorporating Emerging Markets into a global portfolio…



Indexing Can Complement Other Emerging Market Strategies

The overriding importance of “being there”

Core Emerging Market

Index Strategy

RegionalStrategies

Structured / country selection

Traditional active stock

selection

EM Hedge Fund

Long / short or

market neutral

Style Tilt (e.g.–

“Deep Value”)Private Equity



Application of risk budgeting and precise performance attribution

The ‘Active vs. Index’ debate should be over

The Case for “Indexing at the Core”

“Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs.”

-William F. Sharpe, “The Arithmetic of Active Management,” Financial Analysts Journal, 1991.



NTGI Investment Solutions

Emerging Market equity strategies

“Integrated International” and “Total International” equity strategies

Tax-Advantaged Equity (TAE) capabilities for international exposure


IV. Conclusions



Conclusions

Emerging Markets remain a compelling asset class. Core exposure is warranted

The index “vs.” active debate should be over – even in emerging markets.

Index-based exposure is efficient exposure

Sophisticated investors can use a blend of index and higher-risk active strategies to custom tailor their risk exposure.

Use of a core “broader and deeper” international / global benchmark might solve both capacity and asset class evolution issues.

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Integrating Emerging Market Equities into a Global Portfolio

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