Emerging markets: the case and the caveats

Emerging markets occupy an awkward position: economically large, financially smaller, and with a return record that does not match the intuition.

What the category means

The definition is provider-dependent.

Index providers classify markets as developed, emerging or frontier based on economic development, market accessibility, liquidity and regulatory quality.

Classifications differ between providers and change, with countries being promoted and demoted.

Which means an emerging markets fund from one provider may hold a different country set from another.

And the category spans economies with little in common.

The growth argument

And why it is weaker than it sounds.

Emerging economies have grown faster than developed ones over recent decades and represent a growing share of global output.

The intuitive conclusion is that their equity markets should outperform.

The evidence is more complicated: studies examining the relationship between economic growth and equity returns across countries have generally found the relationship to be weak or absent.

The explanations: growth is frequently anticipated and priced; growth is frequently financed by issuing new shares, which dilutes existing holders; and the benefits of growth may accrue to consumers, employees, private companies or the state rather than to listed equity holders.

The return record

Which has been variable.

Emerging markets have had periods of substantial outperformance and periods of substantial underperformance relative to developed markets.

Volatility has been higher.

Drawdowns have been deeper.

And the dispersion between individual emerging countries has been very wide, which means the aggregate conceals enormous variation.

The specific risks

Which differ in kind rather than only degree.

Political and policy risk, including expropriation, capital controls and abrupt regulatory change.

Governance and minority shareholder protection, which vary substantially.

Accounting and disclosure standards.

Currency volatility and, in some cases, controls.

State ownership, where a substantial share of listed companies may be state-controlled with objectives other than shareholder return.

Concentration, since some emerging indices are dominated by a small number of countries and sectors.

And liquidity, which can deteriorate sharply.

The diversification argument

Which has weakened.

Emerging markets historically offered diversification through lower correlation with developed markets.

Correlations have risen with globalisation and rise further during stress.

Which means the diversification benefit is smaller than it was and is not zero.

Currency exposure adds a further dimension that behaves differently.

What allocation makes sense

Approaches.

Market weight, as provided by a global all-country index fund, which requires no view and is the neutral position — typically a modest single-digit to low double-digit percentage of global equities.

Above market weight, which is a deliberate bet on outperformance.

Below market weight or excluded, which is also a deliberate bet and is what a developed-markets index fund implicitly does.

Which means the important point is to know which you are doing, since many investors hold a developed-markets fund without realising they have excluded emerging markets entirely.

The implementation

Practical points.

Broad index funds are available at reasonable cost, though generally higher than developed-market equivalents.

Single-country funds concentrate risk substantially and should be treated as such.

Active management has a somewhat better relative record in emerging markets in some studies, attributed to less efficient markets, though not uniformly.

Currency is generally unhedged, which adds volatility.

And index inclusion decisions by providers have material effects on flows, which is worth knowing when a country is promoted or demoted.

The concentration within the category

Frequently overlooked.

Emerging market indices are dominated by a small number of large economies, with the largest representing a substantial share.

Which means an emerging markets allocation is heavily concentrated in a few countries and, within them, a few sectors and companies.

Checking the country and sector breakdown of any emerging markets fund is worthwhile, since the name implies more breadth than the holdings provide.

The reasonable position

Which requires no forecast.

Hold a global all-country index fund, which includes emerging markets at market weight.

Recognise the additional risks and the additional volatility.

Do not overweight on the basis of a growth argument that the evidence does not support.

Do not exclude entirely without recognising that as a decision.

And note that many developed-market companies derive substantial revenue from emerging economies, which provides indirect exposure regardless.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.