For professional investors

Cracking the
country code
allocation in
emerging markets

WHITE PAPER
For professional investors
September 2017

Jaap van der Hart

Portfolio Manager
Robeco Emerging Stars Equities
2 | Cracking the country code allocation in emerging markets
Introduction Investors in emerging markets
are pretty much guaranteed
an exciting life. There are great
positive stories growth in
productivity, an emerging middle
class, economic reforms and
new markets and companies.
But they have also experienced
financial crises, typically
after periods of rapid but
unsustainable growth, political
turmoil and higher economic
volatility. As a result, equity
returns can differ substantially
from one country to another
within the diverse emerging
market universe.
4 | Cracking the country code allocation in emerging markets
As dedicated active emerging market investors since 1994, country allocation has always
been an important part of our investment process. We view the differences in country returns
not just as a risk factor, but also as an opportunity to achieve better performance by actively
focusing on the most attractive countries. Understanding the top-down drivers in countries
is also important for stock selection and sector allocation in individual emerging markets. In
this paper, we show the role that countries play in emerging markets and highlight the key
elements of our allocation process.

Countries matter
In 2016, Brazil was the best performing emerging country with a US dollar return of 66%.
This was driven by a recovery in commodity prices, the replacement of former president
Dilma Rousseff with a reform-minded government and the start of a significant interest rate
cutting cycle. Over the same period, fellow major Latin American market, Mexico, declined
by 9% due to a weak peso and escalating fears that Trump would abandon the North
American Free Trade Agreement (NAFTA).

These kind of return differences are not abnormal in the emerging market universe. Figure
1 shows the three best and worst countries in terms of performance in the last three years.
These differences are usually large, not just in the last three years, but quite consistently
and the return difference between the best and worst country is often more than 100%.
Furthermore, the average return difference over the last ten years for an emerging country
versus the overall index is 16%.

Figure 1 | The three best and worst country performers 2015-2017

2017 Jan-Aug 2016 2015

Country Return Country Return Country Return
Best Poland 52% Brazil 66% Hungary 36%
Turkey 47% Peru 56% Russia 4%
China 42% Russia 55% India -6%
Worst UAE 10% Mexico -9% Brazil -41%
Russia -3% Egypt -12% Colombia -42%
Qatar -11% Greece -12% Greece -61%
Difference Top 3 -
Bottom 3 48% 70% 60%

Source: MSCI, Bloomberg, Robeco.

Cracking the country code allocation in emerging markets | 5

Figure 2 below gives an insight into the relative importance of countries versus sectors in
emerging markets, using a more sophisticated quantitative analysis. It shows the variance
of returns for the overall market, countries and sectors1. A couple of conclusions can be
drawn from this graph.

The country effect dominates the sector effect, implying that emerging market
performance is driven more by countries than by sectors. This contrasts with developed
markets, where, since 2000, the sector effect has mostly been larger than the country
effect (although recent experience in the euro countries, for example, shows that
countries still matter in developed markets too).

The country effect was strongest in the 90s, when a series of country-specific financial
crises had a large impact on country returns. This has been smaller since the 2008
financial crisis and the resulting changes in global risk appetite which hit all emerging
markets more or less at the same time. Most recently, the country effect has become
more important again with clear differences in domestic political developments and the
effects of commodity price fluctuations.

Figure 2 | Equity return decomposition in emerging markets

Source: Robeco Quantitative Research, data points. December 1992-2016.

The overall conclusion is quite clear, emerging markets as an asset class are far from
homogeneous and performance can differ significantly from one country to another.
There are major differences in structural outlook, position in the economic cycle, the
quality and direction of policy making and the earnings outlook for listed companies. In
1. The market effect measures the variance of the
overall emerging markets index. A large market
effect means that emerging markets generally move
in line. This analysis excludes the return variance of
individual stocks to focus on the relative importance
of the overall market, countries and sectors

6 | Cracking the country code allocation in emerging markets

addition, domestic investors often play a dominant role in local equity markets, which can
create significant differences in valuation and investor sentiment between markets. As a
consequence, this creates interesting opportunities for those global investors who have the
flexibility to actively choose their country exposure.

Well-structured framework
Of course, these return differences alone do not guarantee better performance, investors
have to be able to identify which countries offer the best prospects. Since the inception of
its emerging markets team in 1994, Robeco has used a systematic approach to combine
all the different information sources and factors that are important in assessing this
asset class. As there are many different aspects to consider, it is important to have a well-
structured approach to balance the different factors and ensure that different countries are
compared in a consistent and standardized way.

The country allocation process focuses on the following factors that are consistently
evaluated for all 24 emerging markets that make up the MSCI Emerging Markets Index
(and some of the larger frontier markets).

Factor Sub-factor
Macro Long Term Long-term growth potential
Financial health
Politics, policies and ESG
Macro Short Term Growth surprises
Monetary policy
Changes in financial health
Politics and policies
Earnings Earnings trends
Deviation from consensus expectations
Valuation Valuation multiples
Sector-adjusted valuations
Technical Price momentum
Sentiment and Supply/Demand Investor positioning and sentiment
Supply/demand
Benchmark and regulatory changes

Developments in the economy and the political landscape are most important, which is
reflected in the fact that we have two macro factors. These are a long-term outlook where
we examine factors that are significant over a three- to five-year horizon, and a short-term
outlook, which focuses on what will drive the market for roughly the next six months. Both
of these time frames matter for equity returns.

1 Macro Long Term

In the long-term outlook, we are looking for countries that have the potential to grow, are
unlikely to suffer a financial crisis and have high quality institutions.

Cracking the country code allocation in emerging markets | 7

Growth potential
High economic growth is not a guarantee for higher equity returns, but it does make it
easier for companies to achieve growth. A countrys nominal GDP growth is an important
supporting factor for earnings growth and equity returns. For the long term we can sidestep
cyclical fluctuations, as long-term growth is primarily driven by growth in productive
capacity. The key components we look at are labor supply, investments to grow the capital
stock and productivity growth. The last of these is the most important and also the most
difficult to predict. In addition to the usual demographics and investment and savings data,
we also look at a wide range of competitiveness indicators and try to assess the direction of
change in these indicators.

Financial health
The 2008 global financial crisis rekindled the worlds awareness of the risk of financial
crises. As Reinhart and Rogoffs well-known book This Time is Different shows, this
phenomenon has actually been part of economic life for many centuries. It comes as less
of a surprise to emerging market investors as it has only played a role in their more recent
history. Figure 3 shows the major financial crises in emerging markets since the 1990s.

Figure 3 | Equity returns during major financial crises in emerging markets

Source: MSCI, Bloomberg

8 | Cracking the country code allocation in emerging markets

These crises can wipe out a substantial part of the invested capital, so avoidance is an
important success factor for country allocation. As crises can take many forms sovereign
default, currency devaluation and banking crises, it is important to have a comprehensive
overview of what the potential sources of risk are, rather than just looking at a single factor.

Politics, policies and ESG

Much economic literature has been published on the structural factors that explain the
huge differences in economic welfare worldwide . One key message is the importance of
the quality of institutions, which covers areas such as the rule of law, property rights, free
press and economic freedom. If this is lacking, the process of investment, innovation and
technological progress is severely hampered. Respecting shareholders rights is another
important factor. Without it, there is more risk that somewhere between the investment
and its return, part of the pie will be claimed by the government, corrupt individuals or
controlling shareholders.

There are a wide range of indicators available to assess the institutional quality of
countries, including Transparency Internationals Corruption Perception Index, the
International Country Risk Guides political risk indicators and our own ESG Survey and
RobecoSAM Country Sustainability Ranking. As financial markets are forward-looking, we
are not just interested in the current level of quality, but also the likely path of change.
Thats why we also rate a countrys political direction. It makes a big difference whether a
government is consistently aiming to improve how its economy functions or is held back by
vested interests that have little inclination to change.

2 Macro Short Term

The long-term factors may be most important in the long run, but financial markets also
react significantly to shorter term, cyclical factors. In order to also perform well in the short
term, it is crucial to incorporate these elements. The sub-factors that we review here are:

GDP Growth Surprise

Monetary policy
Changes in Financial Health
Politics and Policies

Research Robeco carried out in 2013 supports selecting the first two factors. If you had
a crystal ball and could see what certain economic figures would be in the future, which
factors would you choose if your focus was on equity returns? It turns out that the two most
important variables are surprises in GDP growth (actual GDP growth versus the expected
growth at the start of the year) and changes in interest rates. Figure 4 shows the results of
perfect foresight strategies for these two sub-factors. Please note that a logarithmic scale is
used, as the performance differences are huge. Of course, these results are not realistic as
unfortunately we do not have perfect foresight. Still, they do show which economic factors
deserve the most attention. In the short to medium term, surprises in GDP growth matter
more than the actual growth levels themselves, while it is evident that monetary policy is
also a key variable for equity markets.

Cracking the country code allocation in emerging markets | 9

In addition, we look at the changes in financial health to also incorporate changes in the
risk level. Some countries may push to achieve higher GDP growth, but if their attempts
require aggressive monetary or fiscal policy, this may backfire in the medium term, leading
to higher inflation and weaker exchange rates, and they may then be forced to tighten
policy later.

Finally, politics and changes in government policy remain a very important factor in
emerging markets. For the short-term macro factor, we are looking out for events that
will play a role in markets in the near future (roughly the coming six months). These
include elections and other political changes, new policies that are being discussed or
implemented and the general direction of policy-making.

Figure 4 | Results for the perfect foresight strategy

Source: MSCI, Consensus Economics, Bloomberg, Robeco

3 Earnings
For equity investors, the ultimate source of the return should come from the earnings
that the companies make. Trends in earnings are therefore an important determinant for
market performance. To some extent, these will already be reflected in macroeconomic
trends within the country, but it adds value to look directly at current earnings trends. For
this factor, we therefore look at changes in analysts earnings estimates and at earnings
surprises in the reported numbers. We also assess whether the consensus estimates
are consistent with the macroeconomic outlook, or whether they are too optimistic or
pessimistic.

4 Valuation
Valuation differences between emerging countries can be significant. For example, markets
like Korea and Russia currently trade well below 10x 2017 earnings, while India, Mexico
and the Philippines are at around 19x earnings. These differences can partly be explained
by diverging growth and risk outlooks, but another major component is the difference
in domestic investor base. Emerging countries differ in terms of the available capital for
investment, regulation and institutional set-up, and investor sentiment, which can lead to
significant differences in valuation. Although these can persist for longer periods of time,
in the long run they tend to converge. Valuation is therefore an important factor and we
use a range of aggregated multiples to assess this at country level. As certain valuation

10 | Cracking the country code allocation in emerging markets

differences may be due to a different sector composition, we also calculate sector-adjusted
valuations to adjust for this effect.

5 Technical
As fundamental long-term investors, price momentum and technical analysis are not the
driving force in our country allocation process. Still, financial markets generally do exhibit
trending behavior, so we do take this into account when making decisions.

6 Sentiment and Supply/Demand

The last factor includes all kind of elements that may influence fund flows from a non-
fundamental point of view. These include the positioning of different market participants,
regulatory changes that affect the behavior of domestic or global investors, changes in
benchmarks like the MSCI Emerging Markets Index, and trends in investor sentiment.
Recent examples are Pakistans inclusion in the MSCI EM Index this year and the
announcement that Chinas A-shares will be included next year. These status changes
affect inflows and are factors that impact markets in the shorter term, so they also need
to be included in our assessment. Another example is the positioning of global emerging
market funds, which we consider a risk factor if one market is a consensus overweight and
sentiment is likely to turn.

Total score
All these factors are combined together in the country allocation framework, which enables
countries to be directly compared with each other. Rankings are assigned to each element
ranging from -- (very poor) to ++ (very good) and are added together to give a total score
for each country. A bottom-up check is then also carried out to determine whether there are
enough liquid investment opportunities for a positive top-down view to be implemented.

Cracking the country code allocation in emerging markets | 11

Implementation is key
Having a good framework is an important foundation, but the actual implementation is
crucial. In our philosophy, we believe in the following elements.

Fact-based
In financial markets, there is no shortage of opinions about what could happen in the
future. To ensure consistency and clarity, we have a full range of data indicators that we
review on a regular basis and that are aligned to the sub-factors that we rate. Figure
5 gives the data overviews for monetary policy and long-term growth potential as an
example. In addition to analyzing the data, there is plenty of important information
that is more subjective, such as political developments and structural economic change.
Here again, we are constantly on the lookout for concrete evidence to either support or
contradict our ideas.

Dynamic
Emerging markets are in a constant process of change, thats why it is crucial to remain
open minded and to be willing to change your opinion if the facts change.

Reality check
Robecos emerging markets team members are all based in Rotterdam, which allows for
easy communication, consistency in the investment process and sufficient detachment
from local sentiment. However, obtaining local information and insights remains
important, which is why team members regularly travel to the regions we look at. In
addition to the company meetings they schedule on these trips, they also allow time to
meet government officials, policymakers, economists and observers like journalists to
check whether our top-down views match the real situation on the ground.

Integrate different perspectives

All the country specialists in Robecos emerging markets team play an active role in
providing input to rate the factors used in this process. In addition, Robecos emerging
debt and credit specialists also give regular input, which gives a different perspective.
Finally, the portfolio construction team makes sure there is solid evidence to support all
the input and that this is consistent across countries, before making its final decision.

12 | Cracking the country code allocation in emerging markets

Figure 5 | Example data sheets (monetary policy and growth potential)

Source: Bloomberg, Datastream, Oxford Economics, IMF, World Bank, World Economic Forum, Robeco

Cracking the country code allocation in emerging markets | 13

Translation into portfolios an integrated approach
After completing the country analysis, the next step is to actually implement it in the
portfolios. We believe in an integrated approach, where we combine the insights from the
country analysis and the bottom-up research on individual companies.

This means that country views are also reflected in the stock selection and sector allocation
within a country. We are not just interested in whether a country is attractive or not, we
also want to know what the positive and negative macro drivers are. For example, if a
country has a new government which is highly motivated to implement reforms, we want
to be invested in companies that are set to benefit from those reforms. In other countries,
we may want to have a higher allocation towards interest-rate sensitive stocks or towards
consumer stocks depending on the macroeconomic outlook. And for countries where we
are not positive on the domestic outlook or the currency, we prefer to be geared towards
exporters.

This integrated approach also works in reverse, as we incorporate the availability of

attractive bottom-up investment opportunities into the final country weighting. If a country
scores very well from a top-down perspective, but we cannot find any attractive stocks with
the right exposure, we will not invest there. Also if a country scores poorly, but there are a
few listed companies that are attractive investments (typically because they are exporting
companies or have other sources of foreign income), then we can still invest. So the
bottom-up view acts as an additional check for the country allocation.

Figure 6 | An integrated investment process

Examples
Currently the two countries with the highest and lowest top-down rankings are Korea and
South Africa. Figure 7 shows how these countries score on the factors in the process and
the key positive or negative elements that we have taken into account. It also shows the
implementation into our main strategies (the Core strategy aims for a more diversified
portfolio and is managed relative to the MSCI Emerging Markets Index, while the Stars
strategy aims for a more concentrated portfolio and has a benchmark-agnostic approach).

As to be expected, Korea is a large position for both strategies, while South Africa has a low
weight. The integrated approach is evident in the South Africa positioning. From a purely
top-down perspective, South Africa would qualify for a larger underweight position, but
because there is one large, attractive stock listed in South Africa which derives the vast
majority of its income from other countries, we choose to have a smaller underweight

14 | Cracking the country code allocation in emerging markets

position. Overall, the funds still have a large underweight (or no weight in the case of the Stars
strategy) in domestically oriented companies in South Africa.

Figure 7 | Factor ratings for South Korea and South Africa

South Korea
Macro Long Term + High level of investment, ranks high on competitiveness
Strong current account surplus, low budget deficit
Improving corporate governance
North Korea risk: large potential impact but very low probability
Macro Short Term 0 Strong growth in exports
Neutral monetary policy, potentially some small rate hikes
Potential Chaebol reform versus socialist policies of President Moon
North Korea will continue to create volatility
Earnings + Positive earnings revisions, outlook significantly improving
Valuation ++ One of the cheapest emerging countries
Technical 0 Neutral
Sentiment 0 On average GEM fund managers have a small underweight
Inflows into equity market from national pension fund NPS
Bottom-up check Neutral Wide range of good companies in which to invest, no need for adjustment
Portfolio positioning Core: overweight position of 5%
Stars: Large weight of 24%
For illustration purposes only

South Africa
Macro Long Term -- Low investment and savings, inflexible labor market
Structural current account deficit
Institutional quality on downward trend under Zuma government
Macro Short Term - Risk of downgrade in credit ratings
Risk of ANC succession in December and populist policies
Earnings -- Large negative earnings revisions across the board
Valuation - More expensive than the GEM average, also when corrected for sectors
Technical 0 Neutral
Sentiment 0 On average GEM fund managers have a small underweight
Local pension funds have a 25% limit on foreign investments
Bottom-up check + Naspers is an attractive stock. It is a holding company for Chinese internet
company Tencent and several other EM internet companies and trades at a
large discount to the sum of its parts
Portfolio positioning Core: underweight position of 1.5%, within South Africa a larger underweight
in domestic companies and a large position in Naspers
Stars: 3.5% position in Naspers only
For illustration purposes only

Cracking the country code allocation in emerging markets | 15

Contribution to performance
The proof of the pudding is in the eating, so it is logical at this point to ask what this country
allocation framework has contributed to performance. Figure 8 shows the cumulative
performance for both country allocation and stock selection for Robeco Emerging Stars
Equities. Country allocation and currency exposure have contributed about one third
of the total relative performance of the strategy. This is also in line with the typical risk
contribution. As the number of countries is relatively small compared to the number of
stocks, there is typically a lower risk contribution from country allocation. Nevertheless, it
has provided an important source of additional alpha.

Country allocation has also made a positive contribution to performance of the Core
strategy. In the 90s, the fund was very successful in restricting losses during the Asian crisis,
and later also benefited from the strong recovery, for example, in 1999 and 2009.

Figure 8 | Cumulative performance attribution Emerging Stars

Source: Robeco Global Performance Measurement.

Figures for Robeco Emerging Stars Equities (EUR) D-share, Gross of fees, based on Net Asset Value, All figures in EUR.
Data as of 31 August 2017. Inception date: November 2006
These performance numbers are single portfolio performance numbers that can be part of a GIPS composite in which
case this information is supplemental to the composite report.
The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.

16 | Cracking the country code allocation in emerging markets

Conclusion
Although the situation may be stable in individual countries, emerging markets as an asset
class will remain in a state of flux. This constantly offers new opportunities, but brings risks
too. As emerging markets are not homogeneous, investors can achieve higher returns by
actively selecting countries with the best prospects and avoiding those with the highest
risks. In our belief, having a well-structured framework and a consistent and dedicated
means of implementing it are crucial elements for success.

We do not see country allocation as a stand-alone part of the process, but believe in an
integrated approach, where the insights gained from country analysis are also reflected
in stock selection and sector allocation within countries. Country allocation has made
a valuable contribution to our performance track record, and will therefore remain an
important part of the investment process.

Going forward, we believe in the words of Heraclitus, The only thing that is constant
is change. So we will keep on looking for countries with solid long-term potential, an
improving economic environment and earnings outlook, an attractive valuation and
supportive equity flows.

Cracking the country code allocation in emerging markets | 17

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18 | Cracking the country code allocation in emerging markets

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product. This material should not be viewed as a recommendation to buy or sell any investment products or to adopt any investment strategies. Nothing in this material
constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to your individual circumstances,
or otherwise constitutes a personal recommendation to you. Robeco Shanghai is a wholly foreign-owned enterprise established in accordance with the PRC laws, which
enjoys independent civil rights and civil obligations. The statements of the shareholders or affiliates in the material shall not be deemed to a promise or guarantee of the
shareholders or affiliates of Robeco Shanghai, or be deemed to any obligations or liabilities imposed to the shareholders or affiliates of Robeco Shanghai.

Additional Information for investors with residence or seat in Australia

This document is distributed in Australia by Robeco Hong Kong Limited (ARBN 156 512 659) (Robeco) which is exempt from the requirement to hold an Australian
financial services licence under the Corporations Act 2001 (Cth) pursuant to ASIC Class Order 03/1103. Robeco is regulated by the Securities and Futures Commission
under the laws of Hong Kong and those laws may differ from Australian laws. This document is distributed only to wholesale clients as that term is defined under the
Corporations Act 2001 (Cth). This document is not for distribution or dissemination, directly or indirectly, to any other class of persons. It is being supplied to you solely
for your information and may not be reproduced, forwarded to any other person or published, in whole or in part, for any purpose. In New Zealand, this document is
only available to wholesale investors within the meaning of clause 3(2) of Schedule 1 of the Financial Markets Conduct Act 2013 (FMCA). This document is not for public
distribution in Australia and New Zealand.

Additional Information for investors with residence or seat in the Dubai International Financial Centre (DIFC), United Arab Emirates
Robeco Institutional Asset Management B.V. (Dubai Office), Office 209, Level 2, Gate Village Building 7, Dubai International Financial Centre, Dubai, PO Box 482060, UAE.
Robeco Institutional Asset Management B.V. (Dubai office) is regulated by the Dubai Financial Services Authority (DFSA) and only deals with Professional Clients and
does not deal with Retail Clients as defined by the DFSA.

Additional Information for investors with residence or seat in Brazil

The fund may not be offered or sold to the public in Brazil. Accordingly, the fund has not been nor will be registered with the Brazilian Securities Commission - CVM nor
have they been submitted to the foregoing agency for approval. Documents relating to the fund, as well as the information contained therein, may not be supplied to the
public in Brazil, as the offering of the fund is not a public offering of securities in Brazil, nor used in connection with any offer for subscription or sale of securities to the
public in Brazil.

Additional Information for investors with residence or seat in Colombia

This document does not constitute a public offer in the Republic of Colombia. The offer of the fund is addressed to less than one hundred specifically identified investors.
The fund may not be promoted or marketed in Colombia or to Colombian residents, unless such promotion and marketing is made in compliance with Decree 2555 of
2010 and other applicable rules and regulations related to the promotion of foreign funds in Colombia. The distribution of this document and the offering of [Shares]
may be restricted in certain jurisdictions. The information contained in this document is for general guidance only, and it is the responsibility of any person or persons in
possession of this document and wishing to make application for the fund to inform themselves of, and to observe, all applicable laws and regulations of any relevant
jurisdiction. Prospective applicants for the fund should inform themselves of any applicable legal requirements, exchange control regulations and applicable taxes in the
countries of their respective citizenship, residence or domicile.

Additional Information for investors with residence or seat in Panama

The distribution of this fund and the offering of Shares may be restricted in certain jurisdictions. The above information is for general guidance only, and it is the
responsibility of any person or persons in possession of the prospectus of the fund and wishing to make application for Shares to inform themselves of, and to observe,
all applicable laws and regulations of any relevant jurisdiction. Prospective applicants for Shares should inform themselves as to legal requirements also applying and any
applicable exchange control regulations and applicable taxes in the countries of their respective citizenship, residence or domicile. This document does not constitute an
offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer
or solicitation.

Additional Information for investors with residence or seat in Peru

The fund has not been registered before the Superintendencia del Mercado de Valores (SMV) and are being placed by means of a private offer. SMV has not reviewed the
information provided to the investor. This document is only for the exclusive use of institutional investors in Peru and is not for public distribution.

Additional Information for investors with residence or seat in Uruguay

The sale of the Fund qualifies as a private placement pursuant to section 2 of Uruguayan law 18,627. The Fund must not be offered or sold to the public in Uruguay,
except in circumstances which do not constitute a public offering or distribution under Uruguayan laws and regulations. The Fund is not and will not be registered with
the Financial Services Superintendency of the Central Bank of Uruguay. The Fund corresponds to investment Funds that are not investment Funds regulated by Uruguayan
law 16,774 dated September 27, 1996, as amended.

Cracking the country code allocation in emerging markets | 19

Contact
Robeco
P.O. Box 973
3000 AZ Rotterdam
The Netherlands
E contact@robeco.com