Most U.S. investor allocations to emerging markets use conventional market-cap-weighted indexes either as benchmarks or as passive portfolios. Over the last decade, investors have increasingly used exchange-traded funds to gain exposure to emerging markets. Most of the assets in these ETFs track conventional benchmarks such as the MSCI Emerging Markets (EM) Index and the FTSE Emerging Index. As of Sept. 30, 2012, 94 percent of U.S.-listed broad global EM equity ETF assets tracked one of these two indexes.1 Designed to be measurement tools, these indexes are now widely used as substitutes for investment portfolios and have, in effect, become the status quo EM core portfolio. Of equal importance, active managers are usually constrained by these same benchmarks.
The conventional benchmarks largely reflect the history of EM growth, though not necessarily its future. They are dominated by sectors that led many frontier countries to EM status, and include exposure to economies such as South Korea and Taiwan, which the International Monetary Fund graduated to advanced status in 1997.2 A lack of alignment between EM economic dynamics and the conventional benchmarks most investors use to gain exposure to emerging markets can result in unintended EM exposures. Benchmarks that use a market-cap-weighting methodology exhibit concentrations in the industries and countries that are the most developed, while crowding out others, including those that are or may be emerging. Investors may wish to consider exposure to sectors, industries or countries that could benefit from the next phase of growth within emerging markets. While conventional benchmarks such as the MSCI EM Index have over 800 constituents, this alone does not provide significant industry or country diversification.
We think most EM investors, when presented with a choice, would prefer more diversification and less concentration in their core EM portfolios. They want better beta. As emerging markets have matured, investors have increasingly been able to make choices beyond conventional benchmarks to build less-concentrated portfolios that allow for more focus on potential growth opportunities within emerging markets.
In our view, delivering better beta requires indexes that are designed primarily for investment use rather than as benchmarks, including those that attempt to reduce concentrations in more mature EM industries, countries and sectors. Examples of such indexes include:
- The S&P Emerging Markets Core Index, designed to provide greater industry diversification in EM core portfolios
- The Indxx Beyond BRICs Index, designed to provide exposure to less mature EM countries
- The Indxx Emerging Markets Domestic Demand Index, designed to provide holdings in less mature EM sectors by offering exposure to domestic demand
- The Indxx Low Volatility Emerging Markets Dividend Index, designed to provide a greater dividend yield and lower relative volatility than the MSCI EM Index
Conventional Benchmarks As Default Investment Positions
The difference in U.S.-based investor behavior at home versus in emerging markets is notable and can be observed using ETFs as a proxy. Domestically, investors express preferences, but in emerging markets, for the most part, they do not. As Figure 1 illustrates, more than half of assets in U.S.-listed, U.S. equity ETFs are in funds that reflect investor preferences for themes, sectors, company size or investment style. Yet just 3 percent of all assets in U.S.-listed, EM equity ETFs are similarly invested. In fact, 97 percent of the $141 billion of U.S.-listed EM equity ETFs track broad country, regional or global EM benchmarks.3
When investors are asked why they do not own an investment vehicle that tracks the S&P 500 Index as their primary U.S. equity holding, they usually provide a cogent answer. However, this same logic and investment acumen is rarely extended to emerging markets, and investors instead choose investments that nearly replicate conventional benchmark indexes. While they may favor sectors, themes, dividends and other approaches when investing domestically, they often do not similarly differentiate in emerging markets.
Conventional Benchmarks: Historical Catalogs?
The use of conventional benchmarks may not allow investors to effectively adapt their holdings to the evolution of emerging markets. Emerging markets evolve faster than conventional EM indexes, which are largely catalogs of what has already happened in emerging markets. An example of this disparity is evident in the inclusion of the advanced economies of South Korea and Taiwan in many EM indexes. South Korean and Taiwanese securities, which comprise 25 percent of the MSCI EM index, derive approximately 75 percent of their revenues from domestic sales and sales to other developed countries, effectively reducing exposure to emerging markets.4
Currently, in emerging economies, some of the potential areas for growth may be found in less mature EM countries, in addition to Brazil, Russia, India and China (BRIC); and in less mature sectors, such as those more driven by domestic demand. EM research is largely focused on sustainable domestic demand—organic, local growth versus export growth—including the themes of infrastructure, urbanization and the rise of the middle class consumer. Many market observers believe these will be the drivers that advance EM countries toward developed-market status.
Another potential benefit of both beyond-BRIC and domestic-demand exposure is reduced volatility. In Figure 2, equal-weighted baskets of less mature countries and sectors are compared with the broad MSCI EM benchmark. Both groupings have had lower beta and standard deviation measures and have provided stronger Sharpe ratios.
Investment portfolios with greater exposure to less mature EM countries and sectors may have the potential to exhibit less volatility than those dominated by exposure to more mature EM countries and sectors. By increasing holdings in EM countries beyond the BRICs, investors may have less exposure to the largest, most developed EM economies, which often receive material flows of risk-on/risk-off markets. Additionally, sectors such as consumer staples, telecom and utilities are traditionally less volatile than more mature EM sectors such as financials, energy and materials (FEM).
However, these less mature EM countries and sectors with high growth potential tend to be underrepresented in conventional EM indexes, and accordingly, in the investment vehicles that are benchmarked to them. For example, in the MSCI EM index, just 30 percent of country exposure is allocated to EM countries besides the BRICs, and 29 percent of sector exposure is allocated to domestic demand-driven sectors.