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Master of Business Administration - MBA Semester III MF0010 Security Analysis and Portfolio Management 4Credits (Book ID:

B1208) Assignment Set- 2 (60 Marks)


Q.1 Study the intensity of competition in the automobile

industry using Michael Porters five factors model. Ans:-Michael Porter has written extensively on the issue of competitive strategy. The intensity of competition in an industry determines that industrys ability to sustain aboveaverage returns. This intensity of competition can be explained by the following five factors: 1. Threat of new entrants: New entrants put pressure on price and profits. Therefore barriers to entry can be a key determinant of industrys profitability. The most attractive segment has high entry barriers and low exit barriers. Although any firm should be able to enter and exit a market, each industry often presents varying levels of difficulty, commonly driven by economies. Manufacturing-based industries are more difficult to enter than many service-based industries. The barriers to entry protect profitable areas for firms and inhibit additional rivals from entering the market. 2. Bargaining power of buyers: The power of buyers describes the impact customers have on an industry. 3. Rivalry between existing competitors: Firms make efforts to establish a competitive advantage over their rivals. The intensity of rivalry varies within each industry. Industries that are concentrated, versus fragmented, often display the highest level of rivalry. 4. Threat of substitute products or services: Substitute products are those products that are available in other industries that meet an identical or similar need for the end user. As more substitutes become available and affordable, the demand becomes more elastic since customers have more alternatives. Substitute products may limit the ability of firms within an industry to raise prices and improve margins. 5. Bargaining power of suppliers: An industry that produces goods requires raw materials. This leads to buyer-supplier relationships Depending on where the power lies, suppliers may be able to exert an influence on the producing industry. Because the strength of these five factors varies across industries (and can change over time), industries differ from each other in terms of inherent profitability. These five competitive forces determine industry profitability because they influence the components of return on investment. The strength

of each of these factors is a function of industry structure. Fundamental analysts analyze industry structure to assess the strength of the five competitive forces, which in turn determine industry profitability. Q2. Using financial ratios, study the financial performance of any particular company of your interest. Ans:-Financial ratios illustrate relationships between different aspects of a small business's operations. They involve the comparison of elements from a balance sheet or income statement, and are crafted with particular points of focus in mind. Financial ratios can provide small business owners and managers with a valuable tool to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. In addition, tracking various ratios over time is a powerful way to identify trends as they develop. Ratios are also used by bankers, investors, and business analysts to assess various attributes of a company's financial strength or operating results. Ratios are determined by dividing one number by another, and are usually expressed as a percentage. They enable business owners to examine the relationships between seemingly unrelated items and thus gain useful information for decision-making. "They are simple to calculate, easy to use, and provide a wealth of information that cannot be gotten anywhere else," James O. Gill noted in his book Financial Basics of Small Business Success. But, he added, "Ratios are aids to judgment and cannot take the place of experience. They will not replace good management, but they will make a good manager better. They help to pinpoint areas that need investigation and assist in developing an operating strategy for the future." Virtually any financial statistics can be compared using a ratio. In reality, however, small business owners and managers only need to be concerned with a small set of ratios in order to identify where improvements are needed. "As you run your business you juggle dozens of different variables," David H. Bangs, Jr. wrote in his book Managing by the Numbers. "Ratio analysis is designed to help you identify those variables which are out of balance." It is important to keep in mind that financial ratios are time sensitive; they can only present a picture of the business at the time that the underlying figures were prepared. For example, a retailer calculating ratios before and after the Christmas season would get very different results. In addition, ratios can be misleading when taken singly, though they can be quite valuable when a small business tracks them over time or uses

them as a basis for comparison against company goals or industry standards. As a result, business owners should compute a variety of applicable ratios and attempt to discern a pattern, rather than relying on the information provided by only one or two ratios. Gill also noted that small business owners should be certain to view ratios objectively, rather than using them to confirm a particular strategy or point of view. Perhaps the best way for small business owners to use financial ratios is to conduct a formal ratio analysis on a regular basis. The raw data used to compute the ratios should be recorded on a special form monthly. Then the relevant ratios should be computed, reviewed, and saved for future comparisons. Determining which ratios to compute depends on the type of business, the age of the business, the point in the business cycle, and any specific information sought. For example, if a small business depends on a large number of fixed assets, ratios that measure how efficiently these assets are being used may be the most significant. In general, financial ratios can be broken down into four main categoriesprofitability or return on investment, liquidity, leverage, and operating or efficiencywith several specific ratio calculations prescribed within each. Q1 Financial Summary Google reported revenues of $6.77 billion for the quarter ended March 31, 2010, an increase of 23% compared to the first quarter of 2009. Google reports its revenues, consistent with GAAP, on a gross basis without deducting traffic acquisition costs (TAC). In the first quarter of 2010, TAC totaled $1.71 billion, or 26% of advertising revenues. Google reports operating income, operating margin, net income, and earnings per share (EPS) on a GAAP and non-GAAP basis. The nonGAAP measures, as well as free cash flow, an alternative nonGAAP measure of liquidity, are described below and are reconciled to the corresponding GAAP measures in the accompanying financial tables. GAAP operating income in the first quarter of 2010 was $2.49 billion, or 37% of revenues. This compares to GAAP operating income of $1.88 billion, or 34% of revenues, in the first quarter of 2009. NonGAAP operating income in the first quarter of 2010 was $2.78 billion, or 41% of revenues. This compares to non-GAAP operating income of $2.16 billion, or 39% of revenues, in the first quarter of 2009. GAAP net income in the first quarter of 2010 was $1.96 billion, compared to $1.42 billion in the first quarter of 2009. Non-GAAP net income in the first quarter of 2010 was $2.18 billion,

compared to $1.64 billion in the first quarter of 2009. GAAP EPS in the first quarter of 2010 was $6.06 on 323 million diluted shares outstanding, compared to $4.49 in the first quarter of 2009 on 317 million diluted shares outstanding. Non-GAAP EPS in the first quarter of 2010 was $6.76, compared to $5.16 in the first quarter of 2009. Non-GAAP operating income and non-GAAP operating margin exclude the expenses related to stock-based compensation (SBC). NonGAAP net income and non-GAAP EPS exclude the expenses related to SBC and the related tax benefits. In the first quarter of 2010, the charge related to SBC was $291 million, compared to $277 million in the first quarter of 2009. The tax benefit related to SBC was $65 million in the first quarter of 2010 and $64 million in the first quarter of 2009. Reconciliations of non- GAAP measures to GAAP operating income, operating margin, net income, and EPS are included at the end of this release. International Revenues - Revenues from outside of the United States totaled $3.58 billion, representing 53% of total revenues in the first quarter of 2010, compared to 53% in the fourth quarter of 2009 and 52% in the first quarter of 2009. Excluding gains related to our foreign exchange risk management program, had foreign exchange rates remained constant from the fourth quarter of 2009 through the first quarter of 2010, our revenues in the first quarter of 2010 would have been $112 million higher. Excluding gains related to our foreign exchange risk management program, had foreign exchange rates remained constant from the first quarter of 2009 through the first quarter of 2010, our revenues in the first quarter of 2010 would have been $242 million lower. Revenues from the United Kingdom totaled $842 million, representing 13% of revenues in the first quarter of 2010, compared to 13% in the first quarter of 2009. In the first quarter of 2010, we recognized a benefit of $10 million to revenues through our foreign exchange risk management program, compared to $154 million in the first quarter of 2009. Paid Clicks Aggregate paid clicks, which include clicks related to ads served on Google sites and the sites of our AdSense partners increased approximately 15% over the first quarter of 2009 and increased approximately 5% over the fourth quarter of 2009. Cost-Per-Click Average cost-per-click, which includes clicks related to ads served on Google sites and the sites of our AdSense partners, increased approximately 7% over the first quarter of 2009 and decreased approximately 4% over the fourth quarter of 2009. TAC - Traffic Acquisition Costs, the portion of revenues shared with Googles partners, increased to $1.71 billion in the first quarter of 2010, compared to TAC of $1.44 billion in the first quarter of 2009. TAC as a percentage of

advertising revenues was 26% in the first quarter of 2010, compared to 27% in the first quarter of 2009. The majority of TAC is related to amounts ultimately paid to our AdSense partners, which totaled $1.45 billion in the first quarter of 2010. TAC also includes amounts ultimately paid to certain distribution partners and others who direct traffic to our website, which totaled $265 million in the first quarter of 2010. Other Cost of Revenues - Other cost of revenues, which is comprised primarily of data center operational expenses, amortization of intangible assets, content acquisition costs as well as credit card processing charges, increased to $741 million, or 11% of revenues, in the first quarter of 2010, compared to $666 million, or 12% of revenues, in the first quarter of 2009. Operating Expenses - Operating expenses, other than cost of revenues, were $1.84 billion in the first quarter of 2010, or 27% of revenues, compared to $1.52 billion in the first quarter of 2009, or 28% of revenues. Stock-Based Compensation (SBC) In the first quarter of 2010, the total charge related to SBC was $291 million, compared to $277 million in the first quarter of 2009. We currently estimate SBC charges for grants to employees prior to April 1, 2010 to be approximately $1.2 billion for 2010. This estimate does not include expenses to be recognized related to employee stock awards that are granted after March 31, 2010 or non-employee stock awards that have been or may be granted. Operating Income - GAAP operating income in the first quarter of 2010 was $2.49 billion, or 37% of revenues. This compares to GAAP operating income of $1.88 billion, or 34% of revenues, in the first quarter of 2009. Non-GAAP operating income in the first quarter of 2010 was $2.78 billion, or 41% of revenues. This compares to nonGAAP operating income of $2.16 billion, or 39% of revenues, in the first quarter of 2009. Interest Income and Other, Net Interest income and other, net increased to $18 million in the first quarter of 2010, compared to $6 million in the first quarter of 2009. Income Taxes Our effective tax rate was 22% for the first quarter of 2010. Net Income GAAP net income in the first quarter of 2010 was $1.96 billion, compared to $1.42 billion in the first quarter of 2009. Non GAAP net income was $2.18 billion in the first quarter of 2010, compared to $1.64 billion in the first quarter of 2009. GAAP EPS in the first quarter of 2010 was $6.06 on 323 million diluted shares outstanding, compared to $4.49 in the first quarter of 2009 on 317 million diluted shares outstanding. Non-GAAP EPS in the first quarter of 2010 was $6.76, compared to $5.16 in the first quarter of 2009. Cash Flow

and Capital Expenditures Net cash provided by operating activities in the first quarter of 2010 totalled $2.58 billion, compared to $2.25 billion in the first quarter of 2009. In the first quarter of 2010, capital expenditures were $239 million, the majority of which was related to IT infrastructure investments, including data canters, servers, and networking equipment. Free cash flow, an alternative non-GAAP measure of liquidity, is defined as net cash provided by operating activities less capital expenditures. In the first quarter of 2010, free cash flow was $2.35 billion. We expect to continue to make significant capital expenditures. A reconciliation of free cash flow to net cash provided by operating activities, the GAAP measure of liquidity, is included at the end of this release. Cash As of March 31, 2010, cash, cash equivalents, and short-term marketable securities were $26.5 billion. On a worldwide basis, Google employed 20,621 full-time employees as of March 31, 2010, up from 19,835 full-time employees as of December 31, 2009. FORWARD-LOOKING STATEMENTS This press release contains forward-looking statements that involve risks and uncertainties. These statements include statements regarding our plans to heavily invest in innovation, our expected stock-based compensation charges and our plans to make significant capital expenditures. Actual results may differ materially from the results predicted, and reported results should not be considered as an indication of future performance. The potential risks and uncertainties that could cause actual results to differ from the results predicted include, among others, unforeseen changes in our hiring patterns and our need to expend capital to accommodate the growth of the business, as well as those risks and uncertainties included under the captions Risk Factors and Managements Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2009, which is on file with the SEC and is available on our investor relations website at investor.google.com and on the SEC website at www.sec.gov. Additional information will also be set forth in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2010, which we expect to file with the SEC in May 2010.

All information provided in this release and in the attachments is as of April 15, 2010, and Google undertakes no duty to update this information. Q3. How is your view of a companys shares different when viewing technically and when viewing fundamentally. Ans:Differences between Fundamental and Technical analysis: 1. Charts vs. Financial statements: A technical analyst approaches a security from the charts, while a fundamental analyst studies the financial statements. Technical analysis is the study of price action and trend, while fundamental analysis focuses on economic supply and demand relationships, in order to calculate the intrinsic value of a financial instrument. Technically, instruments in an uptrend are candidates to be purchased, while instruments in a downtrend are candidates to be sold. Fundamentally, instruments that are below intrinsic value are undervalued and are candidates to be purchased, while instruments that are above intrinsic value are overvalued and are candidates to be sold. By looking at the financial statements (the income statement, the cash flow statement, and the balance sheet) a fundamental analyst determines a companys value. A fundamental analyst tries to uncover the companys intrinsic value. The investment decision based on fundamental analysis is: if the price of a stock trades below its intrinsic value, it is a good investment. Technical analyst sees no reason for analyzing the companys fundamentals as he believes that they are already accounted for in the stocks price. All the information that a technical analyst desires is there in the price of the securities that can be found in the charts. 2. Time horizon: Fundamental analysts take a longer term view of the market when compared to the technical analysts. Technical analysis has a timeframe of weeks, days or even minutes whereas fundamental analysis often looks at data over a number of years. The difference in the time frames is because of the different investing styles of fundamental and technical analysis. It can take a long time for an undervalued stock, uncovered by fundamental analysis, to reach its correct value. Fundamental analysis assumes that if the short-term market is wrong (in valuing a stock at less than its intrinsic value) the price of the stock will correct itself over the long run. This long run can be a number of years in some cases. Also, the data that is analyzed by the fundamental analysts are released over a long period of time. Balance sheet, income statement, cash flow statement, earnings per share that the fundamental analysts use are not published on a daily basis. In contrast, the price and volume data that the technical analysts use are generated on a continuous basis. Thus, part of the

reason that the fundamental analysts use a long-term timeframe, is therefore due to the fact that the data they use to analyze a stock is generated much more slowly than the price and volume data used by technical analysts. 3. Trading vs. investing: The goals of technical and fundamental analysis are different. In general, fundamental analysis is used to make an investment, whereas technical analysis is used for a trade. While the distinction between investment and trading is not very clear cut, we can say that investors buy assets that they believe can increase in value, while traders buy assets that they believe they can sell to somebody else at a greater price. 4. Cause vs. effect: While both approaches have the same objective (that is, to predict the direction of prices), the fundamental analyst studies the causes of market movements, while the technical analyst studies the effect of market movements. The fundamental analyst needs to know why the prices have moved. The technical analyst, on the other hand, attempts to measure the projected effect of the price movements. Although technical analysis and fundamental analysis may seem to be poles apart, many market participants have achieved some success by combining the two. Thus a fundamental analyst may use technical analysis techniques to figure out the best time to enter into an undervalued security. Often, this opportunity is present when the security is severely oversold. By timing entry into a security, the gains on the investment can be greatly improved. Similarly, some technical traders might look at fundamentals to add strength to a technical signal. For example, if a sell signal is obtained after technical analysis, a technical trader might look at fundamental data before going ahead with the decision. Q4. Show how duration of a bond is calculated and how is it used. Ans:-Duration of Bonds Bond Duration is a measure of bond price volatility, which captures both price and reinvestment risk and which is used to indicate how a bond will react in different interest rate environments. The duration of a bond represents the length of time that elapses before the average rupee of present value from the bond is received. Thus duration of a bond is the weighted average maturity of cash flow stream, where the weights are proportional to the present value of cash flows. Formally, it is defined as: Duration = D = {PV (C1) x 1 + PV (C2) x 2+ ----- PV (Cn) x n} / Current Price of the bond Where PV (Ci) is the present values of cash flow at time i. Steps in calculating

duration: Step 1 : Find present value of each coupon or principal payment. Step 2 : Multiply this present value by the year in which the cash flow is to be received. Step 3 : Repeat steps 1 & 2 for each year in the life of the bond. Step 4 : Add the values obtained in step 2 and divide by the price of the bond to get the value of Duration. Example: Calculate the duration of an 8% annual coupon 5 year bond that is priced to yield 10% (i.e. YTM = 10%). The face value of the bond is Rs.1000. Annual coupon payment = 8% x Rs. 1000 = Rs. 80 At the end of 5 years, the principal of Rs. 1000 will be returned to the investor. Therefore cash flows in year 1-4= Rs. 80. Cash flow in year 5= Principal + Interest = Rs. 1000 + Rs. 80 = Rs. 1080 Price of the bond= Rs 924.18 The proportional change in the price of a bond: (P/P) = - {D/ (1+ YTM)} x y Where y =change in Yield, and YTM is the yield-to-maturity. The term D / (1+YTM) is also known as Modified Duration. The modified duration for the bond in the example above = 4.28 / (1+10%) = 3.89 years. This implies that the price of the bond will decrease by 3.89 x 1% = 3.89% for a 1% increase in the interest rates. Example: A bond having Rs.1000 face value and 8 % coupon bond with 4 years to maturity is priced to provide a YTM of 10%. Find the duration of the bond. Ans: P0 = 80 x PVIFA 10%, 4 years + 1000 x PVIFA 10%, 4 years = 80 x 3.170 + 1000 x .683 = 937 rc = 80/937 = 0.857 (current yield) rd = YTM n = 4 years Duration = PVIFA (rd ,n) (1+rd) + [1 ] n dc rr rd rc = 3.170 (1.10) + [ 1 ] 4 .10 .0854 .10 .0854 = 2.977 + .584 = 3.561 years Generally speaking, bond duration possesses the following properties: Bonds with higher coupon rates have shorter durations. Bonds with longer maturities have longer durations. Bonds with higher YTM lead to shorter durations. Duration of a bond with coupons is always less than its term to maturity because duration gives weight to the interim payments. A zerocoupon bonds duration is equal to its maturity. Q5. Show with the help of an example how portfolio diversification reduces risk. Ans:-- Portfolio diversification 'Don't put all your eggs in one basket' is a well-known proverb, which summarizes the message that there are benefits from diversification. If you carry your breakable items in several baskets there is a chance that one will be dropped, but you are unlikely to drop all your baskets on the same trip. Similarly,

if you invest all your wealth in the shares of one company, there is a chance that the company will go bust and you will lose all your money. Since it is unlikely that all companies will go bust at the same time, a portfolio of shares in several companies is less risky. This may sound like the idea of riskpooling, which we discussed earlier in this chapter, and riskpooling is certainly an important reason for diversification. We will use the notion of risk-pooling to explain some forms of financial behaviour, but a full understanding of portfolio diversification involves a slightly wider knowledge of the nature of risk than what is involved in coin-tossing. The key difference between risk in the real world of finance and the risk of coin-tossing is that many of the potential outcomes are not independent of other outcomes. If you and I toss a coin, the probability of yours turning up heads is independent of the probability of my throwing a head. However, the return on an investment in, say, BP is not independent of the return on an investment in Shell. This is because these two companies both compete in the same industry. If BP does especially well in attracting new business, it may be at the expense of Shell. So high profits at BP may be associated with low profits at Shell, or vice versa. On the other hand, all oil companies might do well when oil prices are high and badly when they are low. The important matter here is that the fortunes of these two companies are not independent of each other. The fact that the risks of individual investments may not be independent has important implications for investment allocations, or what is now called portfolio theory. Investments can be combined in different proportions to produce risk and return characteristics that cannot be achieved through any single investment. As a result, institutions have grown up to take advantage of the benefits of diversification. Diversified portfolios may produce combinations of risk and return that dominate non diversified portfolios. This is an important statement that requires a little closer investigation. That investigation will help to identify the circumstances under which diversification is beneficial. It will also clarify what we mean by the word 'dominate'. Table 2 sets out two simple examples. In both there are two assets that an investor can hold, and there are two possible situations which are assumed to be equally likely. Thus, there is a probability of 0.5 attached to each situation and the investor has no advance knowledge of which is going to happen. The two situations might be a high exchange rate and a low exchange rate, a booming and a depressed economy, or any other alternatives that have different effects

on the earnings of different assets. Table 2: Combinations of risk and return Assets differ in expected return and variability in returns. Part (i) illustrates the return on two assets in two different situations. Asset A has a high return in situation 2 and a low return in situation 1. The reverse is true for asset B. A portfolio of both assets has the same expected return but lower risk than a holding of either asset on its own. In (ii) both assets have a high return in situation 2 and a low return in situation 1. For the risk-averse investor asset A dominates asset B. Consider part (i) of the table. In this case both assets have the same expected return (20 per cent) and the same degree of risk. (The possible range of outcomes is between 10 and 30 per cent on each asset.) If all that mattered in investment decisions were the risk and return of individual shares, the investor would be indifferent between assets A and B. Indeed, if the choice were between holding only A or only B, all investors should be indifferent (whether they were riskaverse, risk-neutral, or risk-loving) because the risk and expected return are identical for both assets. However, this is not the end of the story, because the returns on these assets are not independent. Indeed, there is a perfect negative correlation between them: when one is high the other is low, and vice versa. What would a sensible investor do if permitted to hold some combination of the two assets? Clearly, there is no possible combination that will change the overall expected return, because it is the same on both assets. However, holding some of each asset can reduce the risk. Let the investor decide to hold half his wealth in asset A and half in asset B. His risk will then be reduced to zero, since his return will be 20 percent which ever situation arises. This diversified portfolio will clearly be preferred to either asset alone by risk-averse investors. The risk-neutral investor is indifferent to all combinations of A and B because they all have the same expected return, but the risk lover may prefer not to diversify. This is because, by picking one asset alone, the risk lover still has a chance of getting a 30 per cent return and the extra risk gives positive pleasure. Riskaverse investors will choose the diversified portfolio, which gives them the lowest risk for a given expected rate of return, or the highest expected return for a given level of risk. Diversification does not always reduce the riskiness of a portfolio, so we need to be clear what conditions matter. Consider the example in part (ii) of Table 2. As in part (i),

both assets have an expected return of 20 per cent. But asset B is riskier than asset A and it has returns that are positively correlated with A's. Portfolio diversification does not reduce risk in this case. Risk-averse investors would invest only in asset A, while risk-lovers would invest only in asset B. Combinations of A and B are always riskier than holding A alone. Thus, we could say that for the risk-averse investor asset A dominates asset B, as asset B will never be held so long as asset A is available. The key difference between the example in part (ii) of Table 2 and that in part (i) is that in the second example returns on the two assets are positively correlated, while in the former they are negatively correlated [Note]. The risk attached to a combination of two assets will be smaller than the sum of the individual risks if the two assets have returns that are negatively correlated. Diversifiable and nondiversifiable risk Not all risk can be eliminated by diversification. The specific risk associated with any one company can be diversified away by holding shares of many companies. But even if you held shares in every available traded company, you would still have some risk, because the stock market as a whole tends to move up and down over time. Hence we talk about market risk and specific risk. Market risk is nondiversifiable, whereas specific risk is diversifiable through risk-pooling. Box 3 discusses the issue of whether all firms should diversify the activities in order to reduce risk. Beta It is now common to use a coefficient called beta to measure the relationship between the movements in a specific company's share price and movements in the market. A share that is perfectly correlated with an index of stock market prices will have a beta of 1. A beta higher than 1 means that the share moves in the same direction as the market but with amplified fluctuations. A beta between 1 and 0 means that the share moves in the same direction as the stock market but is less volatile. A negative beta indicates that the share moves in the opposite direction to the market in general. Clearly, other things being equal, a share with a negative beta would be in high demand by investment managers, as it would reduce a portfolio's risk. The capital asset pricing model, or CAPM, predicts that the price of shares with higher betas must offer higher average returns in order to compensate investors for their higher risk. For example, Two stocks whose returns move in exactly together have a coefficient of +1.0. Two stocks whose returns move in exactly the opposite direction have a correlation of -1.0. To effectively diversify, you should aim to find investments that have a low or negative correlation. The banking stocks (or the technology stocks) would

have a high positive correlation as their share prices are driven by common factors. As you increase the number of securities in your portfolio, you reach a point where you have diversified as much as is reasonably possible. When you have about 30 securities in your portfolio you have diversified most of the risk. Q6. Study the performance of any emerging market of your choice. Ans:-Emerging market With emerging market economies like India and China growing at nearly 10%, you may be feeling pain from all the criticism from pundits and advisers that you are a myopic, short-sighted American for not allocating enough to emerging market equities. According to Vanguard, the average allocation to emerging market equities among US household investors is still only 6%. Shouldn't the percentage of your equity portfolio invested in emerging markets equities be roughly in line with the proportionate share of emerging-market stocks to total global stock-market capitalization or around 10% to 15% of an investor's total equity portfolio? It seems natural to expect that the powerful economic growth of emerging markets such as Brazil and China will lead to higher stock market returns than in the slower growing markets such as the U.S. and Europe. So should emerging market equities be a bigger part of your portfolio? In fact, US household investors may, at least for the moment, be properly weighted in emerging markets. For the following reasons higher potential growth may not justify investing heavily right now in emerging market equities and instead you may want to be gradually increasing your allocation over time: First, 12% economic growth in a country like India has not necessarily meant 12% market returns. While there is certainly reasonable evidence to support expectations of longterm growth in markets like India, China, Brazil, etc., as reported in this Wall Street Journal article - studies suggest that strong economic growth often does not translate into strong stock returns. One study, which looked at market returns in 32 nations since the 1970s, concluded that stock gains and economic performance can diverge dramatically. University of Florida finance professor Jay Ritter found, for example, that stocks in Sweden posted a mean return of better than 8% a year from 1970 through 2002, even though GDP grew at an annualized pace of just 1.8%. In contrast, while GDP expanded more than 5% annually in South Korea from 1988 to 2002, the mean stock return was only 0.4% a year. 'A healthy economy isn't a guarantee that established companies will attract enough

capital and labor to expand sales and earnings stronglypartly because they have to compete with newer ventures for resources,' Dr. Ritter says. More basically, since markets are largely efficient, investors have long ago anticipated potential for equities in places like China. Right now, by many measures, it would appear that valuations for US and MSCI Emerging Markets Index on a trailing P/E basis are roughly inline. Second, even if average annual returns from emerging markets exceed developed markets, emerging markets are still materially more volatile, and this volatility will not just keep you awake at night, it will erode your returns over time through the process of volatility drag. My colleague explains in this article how volatility drag will reduce your returns. Right now, the 3-year standard deviation of emerging market returns is 32.83 versus 24.27 for the S&P500, a difference that translates into roughly a 3% drag on your cumulative return. And while the 60-day volatility on US Large-Cap Equities has now dropped all the way down to 10.99%, the 60-day emerging market volatility actually rose slightly this quarter to 19.55% (see chart below for period ending December 31, 2010): click to enlarge Third, emerging market indexes are less efficient investment vehicles which makes a big difference over time for prudent, long-term investors. Most emerging market funds are significantly more expensive than US funds - often hundreds of basis points more. Our firm recommends low cost funds such as iShares MSCI Emerging Market Index (EEM), and Vanguard Emerging Markets (VWO). But even these low-cost funds face higher costs than US equity funds. Compare Vanguard's VWO at 0.27 expense ratio vs. Vanguards S&P500 Index Fund (VOO) at 0.06%. If you are investing within a fund family such as Fidelity, your choice for emerging markets is an actively managed fund with an annual cost of 1.14% versus Fidelity's S&P500 Index at only 0.10% (This is why if you really seek more exposure to emerging markets economic growth, a more efficient way to gain exposure is through multinationals traded on US exchanges S&P500 companies derive about 50% of their revenue from abroad, with about a third of that coming from emerging markets). So higher economic growth may not lead to higher returns on emerging markets equities, volatility drag is likely to erode much of this potential higher return, and higher investment costs are certain to drag the return down even further. In our dynamic asset allocation process, emerging markets allocations are likely to grow along with other equity allocations over the next few years assuming volatility continues to decline. But, right

now, it appears that the average American household is not necessarily being naive and xenophobic when they choose to be underweighted in emerging market equities.