Ryann Marotta, CFP®, CFA, is a senior portfolio manager at Northern Trust, responsible for the implementation and oversight of sophisticated investment strategies on behalf of clients. In her role, she develops relationships with clients to understand their unique financial situations and deliver portfolio solutions in their best interests.
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The past decade catapulted emerging market economies to 39 percent of global GDP and 26 percent of global market capitalization. Even when adjusting for the accessibility of investment (the free-float), the figures are significant at 26 percent and 13 percent, respectively, according to Bloomberg and the International Monetary Fund. When examining each emerging market country, their contributions to these figures vary dramatically relative to each other. Yet as emerging markets collectively continue to gain prominence on the global stage relative to developed countries, we expect investors to be rewarded over time—not for increased growth, but rather increased risk.
Many investors, however, are less likely to share our enthusiasm. Emerging markets generated 4 percent annually in total return during the 2010s, the asset class’s worst decade for investment performance, according to MSCI. As a result, many investors are assessing their clients’ allocation to emerging markets; either conceding to concerns for the decade-long breakdown in risk and reward, or embracing the opportunity for potential outperformance given each client’s objectives and expectations.
An Evolving Investment Landscape
To understand the current dynamics within emerging markets, it helps to appreciate their evolution over recent decades.
Institutional investment in emerging markets gained traction in the 1980s as an opportunity to benefit from uncorrelated equity returns derived from growing economies in a globalizing world. Where investors go, MSCI tends to follow. It introduced its preeminent Emerging Markets Index in 1987, at which point emerging markets comprised less than 1 percent of the MSCI All Country World Index (ACWI) market capitalization.1
At the time, the investment landscape within emerging market countries was far more challenging, with limited opportunities to access financial markets, which also lacked liquidity, transparency, and regulatory oversight. While these basic tenets of investing still prove problematic in emerging markets, the early days also lacked the internet, which has since improved communication and access to information.
In the following decades, emerging markets have transformed nonlinearly. The early years witnessed a regional tug of war between Latin American and Asian constituent countries vying for the highest weighting in the MSCI Emerging Market Index, while the overall emerging market weighting within the global arena remained fairly low. However, that weighting has steadily increased with time.
Enter China in 1996. Though only commanding an initial market capitalization weighting of less than 1 percent within the MSCI Emerging Market Index in 1997, its GDP weight comprised more than 17 percent among constituent countries within the index.2 As China slowly allowed its domestic companies access to foreign investment, investors jumped at the opportunity to access an economy that already outpaced all of its emerging market counterparts.
China has since risen to dominance, creating a country concentration within the MSCI Emerging Markets Index greater than 34 percent as Chinese investment opportunities expanded, allowing companies to list in Hong Kong and overseas. More recently, China allowed foreign direct investment on its domestic exchange and MSCI quickly introduced these companies to its index. Furthermore, the weights for Taiwan, Korea, and India have increased so much that Asia’s regional influence now makes up more than 70 percent of the index country weighting.
Similar to shifts in regional and country weightings, sector weightings within the MSCI Emerging Market Index have also changed dramatically. Investment in emerging markets had long been considered an investment in commodities, historically driven by large cyclical energy and materials companies reaping the benefits of abundant national resources. As recently as the 2000s, an investment in emerging markets could mean access to Chinese equities servicing the commodity needs of nearby developed nations. Today, the index sector breakdown still carries a heavier cyclical weighting, though the weighting to information technology and internet companies operating as consumer discretionary and communication services companies is steadily increasing.
While recent investment performance has proven underwhelming for emerging markets, investors experienced very different returns during the 2000s. The decade gave rise to “BRIC,” a phrase to easily reference top performing countries—Brazil (total return of 312 percent), Russia (713 percent), India (288 percent), and China (180 percent).3 As the S&P 500 Index experienced poor returns over the decade, investors relished in emerging market outperformance, paving the way for broad adoption of the asset class.
Growth on the Horizon
The investment thesis for emerging markets remains unchanged from the 1980s. Emerging market nations continue to benefit from secular growth trends—favorable demographics, resource-rich land, and a globalizing society.
Large and growing populations with an increasing middle class provide emerging markets with a robust labor force by which to service the manufacturing needs of growing global companies. Of the world’s 2 billion millennials, nearly 90 percent reside in emerging market countries—with 400 million living in China alone, more than the entire U.S. population.4 These youthful population dynamics increase domestic consumption of natural resources and goods and services, subverting the myth of export-dependent growth.
However, the true change agent within the modern-day growth story for emerging markets is technology. These tech-driven generations have positioned emerging market economies at the forefront of the digital revolution and enable them to “technology-jump” prior stages in the traditional development of countries. At one end, consider the example of a rural farmer using the alarm clock function on their new smartphone, having never owned an alarm clock previously. At the other end, the Chinese quickly and broadly adopted e-commerce giant Alibaba and its affiliate, Ant Group, the world’s largest financial technology platform, bypassing traditional retail outlets.
Collectively, these forces within emerging markets are creating innovation born out of necessity to meet the growth in demand, not just globally, but on the home front.
Lastly, considering equity valuations, emerging market equites are more attractive relative to their developed market counterparts. At a time when many stocks are notoriously expensive, emerging market stocks are relative bargains.
Time May Pass, but the Risks Remain
After a decade of lackluster performance in emerging markets, is the expectation for outsized return still worth the risk? Since its inception, investment in emerging markets has been a carefully calculated dance requiring the balancing of distinct types of overlapping risks.
Previously, the historical volatility of these risks may not have been significant to globally diversified investors given the limited overall weight of emerging markets within a market-cap-weighted portfolio. However, as the weight of emerging markets has increased to 13 percent of the MSCI All Country World Index, it is time investors understand the details.5
In the late 1990s, many emerging market economies were shaken by financial crises. As a condition of their bailout, the International Monetary Fund and World Bank required countries in southeast Asia, Russia, and Brazil to undertake reforms to gradually strengthen regulatory oversight to international standards, increase transparency in the financial sector, and improve market efficiency.6 Though strides were made, emerging market investors continue to experience the established investment risks including geopolitical risk, government risk, fraud risk, and currency risk.
The extent to which these risks may be apparent in a particular country can justify MSCI to downgrade their status from emerging market to frontier market or worse, as is underway this year with Argentina, where increased capital controls deteriorated market accessibility standards.7 However, downgrades should not prove problematic for client portfolios that are diversified because such countries often lack the capitalization to influence returns.
China: the Elephant in Emerging Markets Indices
However, therein lies the crucial risk within emerging markets—the increasing concentration of China in market capitalization, number of constituent companies, share of GDP, and by extension, its influence over global equity returns. As of July 31, 2021, China’s weight within the MSCI Emerging Market Index was just over 34 percent, down from 40 percent at the end of 2020. Even though China’s economic growth has tapered since arriving on the investment scene in 1997, this concentration has significant impacts on investors, as China is now the third largest country in the MSCI All Country World Index.
In the second quarter of 2021, investors experienced China’s influence over global capital markets firsthand. Despite China’s increasing relevance on the world stage, it still exhibits many of the traditional risks associated with emerging market nations, particularly government and governance transparency risks tied to its communist regime. As the Chinese government amplified its regulatory oversight, investors fled Chinese equities, crashing emerging market investment flows and values, which then rippled through developed markets. These risks should be carefully considered, as the Chinese government targets industries and companies of strategic importance, often intersecting with investor interest.
In addition, the benefit of China’s large millennial generation is muted by other demographic constraints arising from its now-terminated one-child policy. Overall, the Chinese population is rapidly aging with a relatively shrunken labor force unable to adequately provide for its seniors and continued economic growth.
The Case for Emerging Markets
Portfolio allocations to emerging markets have been historically smaller as a proportion of global equities and achieved through passive investment. However, as emerging markets continue to gain prominence on the global stage, the resulting returns come with additional risks associated with increasing market share and concentration. These risks—already reflected in market prices—suggest the expected return for emerging market equities exceeds that of developed markets.
Undoubtedly, emerging markets continue to serve a purpose in investment portfolios. Yet perhaps the better questions are to what degree and how? We suggest advisers look to their clients and seek to intimately understand their goals and objectives to determine an appropriate allocation size—one that clients can comfortably embrace today with the expectation of long-term return.
Lastly, the elevating risk dynamics within emerging markets warrant a closer review of the investment strategy applied for the asset class. Passive investment provides investors the market return tax efficiently at relatively less cost. While meaningful and sustainable alpha is rare, the use of active management may help mitigate concentration risks otherwise inherent in a passive indexed approach though at higher cost and turnover. In evaluating active management, seek managers skilled in the nuances of technology-driven economies that operate within an imperfect governance framework and are better able to adapt to the changing landscape and emerging opportunities than an index.
This document is a general communication being provided for informational and educational purposes only and is not meant to be taken as investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective, or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting, or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions, or inflation. This material has been obtained from sources believed to be reliable, but its accuracy, completeness, and interpretation cannot be guaranteed. Northern Trust and its affiliates may have positions in, and may effect transactions in, the markets, contracts, and related investments described herein, which positions and transactions may be in addition to, or different from, those taken in connection with the investments described herein.
LEGAL, INVESTMENT, AND TAX NOTICE. This information is not intended to be and should not be treated as legal, investment, accounting, or tax advice.
PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Periods greater than one year are annualized except where indicated. Returns of the indices also do not typically reflect the deduction of investment management fees, trading costs, or other expenses. It is not possible to invest directly in an index. Indices are the property of their respective owners, all rights reserved.
- Bambaci, Juliana, Chin-Ping Chia, and Billy Ho. 2012, October. “Built to last: Two Decades of Wisdom on Emerging Markets Allocations.” MSCI. www.msci.com/documents/10199/7fc700a7-3216-457a-88da-f50e71d8a15e.
- Xu, Shuo. “The Rise of Emerging Markets and Asia: Performance-Leadership Change and Market Fundamentals.” MSCI. www.msci.com/insights-gallery/emerging-markets.
- Wilson, Dominic, Alex L. Kelston, and Swarnali Ahmed. 2010, May 20. “Is this the ‘BRICs Decade’?” Goldman Sachs Global Economics, Commodities and Strategy Research. www.goldmansachs.com/insights/archive/archive-pdfs/brics-decade-pdf.pdf.
- Grozdanovic, Nikola. 2020, April 17. “The next global frontier: Millennial investors are driving growth in emerging markets.” World Finance. www.worldfinance.com/markets/the-next-global-frontier-millennial-investors-are-driving-growth-in-emerging-markets.
- Source: FactSet. Total return for Bovespa Index (Brazil), RTS Index (Russia), BSE SENSEX (India), and MSCI China H (China) for the period 1/1/2000 or since inception though 12/31/2009.
- International Monetary Fund. 2000, June. “Recovery from the Asian Crisis and the Role of the IMF.” www.imf.org/external/np/exr/ib/2000/062300.htm.
- MSCI Market 2021 Classification. www.msci.com/market-classification.
Emerging Market Risks
- Financial and Capital Market Risk. The strength, stability, breadth, and depth of markets to allow for the safe and efficient allocation of capital between businesses and investors at a reasonable cost.
- Governance and Transparency Risk. The ability of companies to operate independently and fairly while reporting on their actions publicly. Strong governance is typically diminished by State-Owned Enterprises (SOEs), in which governments exert control over strategic companies and sectors of national interest.
- Foreign Investment and Currency Risk. The ability for foreign investors to safely invest capital without fear of legal ramifications, investor frictions, or currency manipulation.
- Geopolitical and Government Risk. This remains a top concern for investors and includes abrupt policy changes, civil unrest, and corruption both within a country and across borders.