What are the main investment behaviors of emerging markets and component stocks? In their January 2014 paper entitled “Studies of Equity Returns in Emerging Markets: A Literature Review”, Yigit Atilgan, Ozgur Demirtas and Koray Simsek survey the stream of research on emerging markets equity return predictability and volatility. This survey covers articles in the top four finance journals (Journal of Finance, Journal of Financial Economics, Journal of Financial and Quantitative Analysis and Review of Financial Studies) and the three finance journals that focus on emerging markets (Emerging Markets Finance & Trade, Emerging Markets Review and Journal of International Money and Finance). Based on detailed reviews of 54 articles published in these journals over the past three decades, they conclude that:
- Emerging markets comprise about 13% of world free float and 20% of the total world equity market capitalization.
- Trading frictions are high and analyst coverage thin in emerging markets.
- Emerging market returns exhibit a: (1) negative relationship with volatility measured as standard deviation of monthly returns; but, (2) positive relationship with market downside risk.
- Regarding common return factors among emerging markets:
- While not pervasive across countries, there is some evidence for the size effect.
- Most markets offer a value premium that is similar for small and large capitalization stocks.
- Most markets exhibit the momentum effect, with correlation of momentum returns across countries weak. The effect is stronger for small stocks and within countries with individualistic cultures.
- Regarding other return predictors among emerging markets:
- Illiquidity (measured as frequency of zero daily returns rather than transaction costs) relates positively to future returns, more strongly in countries with high political risk and poor investor protection.
- Neither global nor country-level stock betas explain future stock returns.
- Among fundamental-to-price ratios, cash flow-to-price is the best return predictor. A model based on country market return, country cash flow-to-price ratio and country momentum factors is successful.
- Market liberalization actions (improving access for local and foreign investors) generally boost stock performance.
- IPOs, especially those relatively large compared to total market capitalization, tend to depress country market stock returns.
- Regarding emerging markets return volatility:
- Average weekly return volatility of emerging markets stocks is lower than that of U.S. stocks of the same industry, size, age and market-to-book ratio.
- However, emerging markets exhibit on average about three times more equity market cycles and higher low-frequency volatility than developed markets.
- Volatility persistence supports successful use of technical analysis.
- Market liberalization actions generally reduce volatility.
- The correlation of returns between emerging and developed markets has risen dramatically over recent years, and examples of contagion across markets have become more frequent.
In summary, evidence from the body of research on emerging stock markets indicates some factor-dependence similarities with, and volatility differences from, developed markets. In recent years, emerging and developed markets are more interdependent than previously.
Cautions regarding conclusions include:
- In general, sample breadths are small and sample durations are short for emerging markets compared to developed markets.
- High trading frictions generally inhibit exploitation of gross anomalies found in emerging markets.
- Aggregate snooping bias in the research stream argues for raising the bar for anomaly significance over time (see “Taming the Factor Zoo?” and “Navigating the Data Snooping Icebergs”).
