Investment Spotlight: DFA Emerging Markets Core

Portfolio weight: varies from ~0-20% of typical client portfolios

Annualized Total Return as of 5/31/2007

Perhaps surprisingly, China is not included in this list. Due to recent positive structural and legislative changes in China, DFA has decided to include it in its emerging markets funds starting with the 3rd quarter of 2007.

Emerging markets equity was the top performing asset class in Kochis Fitz portfolios over the past 1, 3 and 5 years. Economic reforms, sounder policies, rapid growth, and robust international trade drove returns. At the same time, many emerging countries worked to contain inflation, support strong GDP growth, and provide greater liquidity and increased transparency in their capital markets. The increase in, and subsequent stabilization of commodity prices at elevated levels over the past few years helped many emerging market exporters build wealth without escalating inflation in their home countries.

Despite the stellar returns over the past five years, investors should be aware that this asset class is a good deal more volatile than many others, as demonstrated by the recent swings in the Chinese stock market. This current episode was largely based on internal Chinese market speculation. Moreover, many emerging countries still harbor real political and economic risks and have shallow public markets or restrictive policies on foreign investments. For example, in contrast to developed markets, emerging markets include several countries that are highly skewed toward just a few companies. Russia’s top ten companies represent 64% of the country’s total stock market capitalization. Thus, we prefer to expose our clients’ portfolios to the largest and most liquid capital markets in emerging countries and expect to expand coverage as additional markets demonstrate a minimum level of sophistication and depth.

To gain exposure to companies in emerging markets, we currently use the Dimensional Fund Advisors Emerging Markets Core Equity Portfolio (DFCEX). This is a customized emerging markets fund initially designed and created by Kochis Fitz and Dimensional Fund Advisors (“DFA”) for our clients to capture the higher return and diversification benefits of tilting toward small cap and value stocks in DFA’s emerging markets portfolios. These tilts, along with the fund’s exclusion of emerging countries that are below DFA’s prespecified level of market sophistication and maturity* have enabled DFCEX to outperform the MSCI Emerging Markets Index by 10.4% (49.0% vs. 38.6%) over the past year! Small and value stocks in emerging markets have had significantly higher average returns than the broad emerging markets universe over the past 3 and 5 years. Due to their relatively low correlation with the developed equity markets, emerging markets provide an additional source of diversification to US investors along with very attractive prospective returns due to high potential rates of economic growth. Even a small allocation to those stocks can significantly improve the risk/return profile of a portfolio.

Currently, DFCEX has $1.2 billion invested in the companies in Brazil, Chile, Czech Republic, Hungary, India, Indonesia, Israel, Malaysia, Mexico, Philippines, Poland, South Africa, South Korea, Taiwan, Thailand, and Turkey. As of April 30, 2007, the approximate regional allocation for DFCEX is as indicated in the graph below:

Employing a strategy of passive exposure to a very broad array of specific company opportunities, DFCEX invests in more than 2,000(!) companies, with an average market cap of $13.2 billion, but a median market cap of just $0.3 billion. Reflecting the impact of the large companies on the average market cap, almost one tenth of the fund’s total value can be accounted for by its 10 largest holdings (0.4% of the companies in the fund).

Selected Investments

The following investments are representative of holdings in DFCEX:

Reliance Industries Limited is India’s largest petrochemical firm and among the country’s largest companies. The firm is organized into three business segments, which include exploration and production of oil and gas; refining and marketing of petroleum products, and petrochemicals, including the manufacturing and marketing of polymers, polyester, polyester intermediates and chemicals. It has production facilities at three locations in India and four locations in Europe, and exploration and production interests in India, Yemen and Oman. In 2006, Reliance Industries Limited generated $3.4 billion of earnings before depreciation, interest and tax on $20.1 billion of total income, about the same as American Express Company.

Samsung Electronics Co., Ltd., based in Korea, is one of the world’s largest semiconductor manufacturers. It makes many kinds of consumer devices, including DVD players, big-screen televisions, and digital cameras; computers, color monitors, LCD panels, and printers; semiconductors such as DRAMs, SRAMs, and flash memory; and communications devices. In 2005, Samsung generated $7.5 billion of net income on $79.5 billion of revenue.

Cemex S.A.B. de C.V., based in Mexico, is one of the giants in the world cement industry. About 75% of CEMEX’s sales come from cement; the company has an annual production capacity of some 98 million tons. It is investing $500 million to increase capacity. It also makes ready-mix concrete, aggregates, and clinker. CEMEX’s operations are concentrated in North America and Europe, but it also operates in the Middle East, South America, and the Pacific Rim. North America accounts for around 40% of sales. In 2005, Cemex generated $2.1 billion of net income on $15 billion of revenue.

* DFA uses quantitative and qualitative criteria in their country
selection process. The quantitative criteria include a minimum of $10 billion in market capitalization, a minimum of 20 publicly traded companies and a average daily turnover of $10-20 million. These criteria ensure that there are sufficient assets that can be realistically invested and traded in any country without severely impacting the markets. On the qualitative side, there are criteria regarding market microstructure, securities markets regulations and legal and economic institutions. Countries in the MSCI Emerging
Markets Index that are excluded from DFCEX include Argentina, Colombia, Egypt, Jordan, Morocco, Pakistan, Peru and Russia.