Beyond The Broad Benchmark
The vast growth of emerging market equities over the past few decades has garnered the attention of the investment community. Although it is now commonplace to invest in emerging markets, the majority of investors today simply allocate to emerging markets rather than within emerging markets. Because of vast differences across developing countries, opportunities may exist for generating alpha through managing geographic allocations or by examining smaller lesser-known markets. Likewise, tactical allocations across size ranges and sectors may also be of interest in emerging markets. In addition, investment themes that have become popularized in the U.S.—such as high-dividend investing—also show promise in emerging markets. While index providers are perhaps best known for defining emerging markets, index innovation has more recently been a central factor in encouraging the investment community to look deeper at opportunities within emerging market equities.
Trends In Emerging Markets Investing
The term “emerging markets” was first coined by the International Finance Corporation (IFC) in 1981. During that year, the IFC launched the world’s first emerging market equity indexes—the Emerging Markets Database (EMDB) indexes—laying the groundwork for the investment community to measure the equity market performance of these developing economies and to begin considering adding these countries to equity portfolios. (Note that the EMDB indexes were acquired by Standard & Poor’s in 2000 and serve as the basis for many of S&P Dow Jones Indices current emerging market indexes.)
At the time the EMDB indexes were launched, equity markets in developing countries were extremely small and illiquid and received relatively little interest from institutional investors. However, over the next few decades, emerging equity markets experienced enormous growth and development. At the end of 1985, the total market capitalization of equities listed on emerging market stock exchanges was $171 billion and represented less than 4 percent of global stock market capitalization. By the end of 2011, emerging market stock market capitalization had grown to approximately $12 trillion and represented more than 25 percent of global stock market capitalization (Figure 1).
As emerging market investing grew in popularity over the years, new concepts were introduced. In 1996, the IFC, recognizing the need for an additional tier of smaller, less liquid markets, introduced the IFCG Frontier Index, cementing the term “frontier markets” in the financial lexicon. The BRIC countries (Brazil, Russia, India and China) were popularized in the early 2000s, and their high growth spawned an array of country acronyms spanning the emerging and frontier markets. Next-11 (Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, South Korea, Turkey and Vietnam), CIVETS (Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa) and MIST (Mexico, Indonesia, South Korea and Turkey) are just a few of the country groupings that have been identified by economists and analysts as being likely to experience strong growth.
As emerging markets grew and more countries became investable, the need for effective and transparent country classification methodologies increased. As the designers and calculators of global equity indexes, index providers naturally assumed this role in the capital markets.
Country classification decisions are made based on quantitative as well as qualitative factors. Index providers generally publish robust, transparent country classification methodologies, solicit feedback from institutional investors, and ultimately have committees that are independent from their commercial management responsible for making final decisions based on information received through this research and consultation process.
In the past, country classification methodologies focused on economic and market development criteria as well as overt restrictions on foreign investment. Things like gross national income (GNI) per capita, the size of the stock market in relation to its economy, and relative absence of controls and accessibility restrictions on foreign investors were typical screening factors.
More recently, attention is also being given to the presence of strong structural and infrastructure facilities for trading, repatriation of funds, transparent and nonpunitive tax regimes, easy access to foreign exchange and strong internal controls via high regulatory standards.
Over time, emerging markets have not only grown in size and importance, but their composition and characteristics have changed dramatically. In the 1980s, emerging markets were largely recognized as immature economies with low levels of GNI per capita. Today’s emerging markets have significant diversity in terms of their economic maturity and market size, and in some cases are major drivers of global economic growth. While as a group they are clearly less economically developed than their developed-market counterparts, today’s emerging markets arguably have more similarity in terms of their level of market accessibility than their level of economic development.
The tremendous growth and development of emerging markets has resulted in their being viewed as a core asset class by many investors. Despite this trend, the use of sophisticated asset-allocation strategies within emerging market equity portfolios remains extremely limited. Today the vast majority of emerging markets assets is either indexed directly to broad emerging market benchmarks or is managed by active managers with broad, core mandates tied closely to these same indexes. Few investors implement tactical asset allocation by actively varying country, sector or size exposures, as is commonplace in their developed-markets portfolios.
Emerging Markets Are Not Homogenous
While emerging markets have widely varying levels of economic development, they likewise have economies and equity markets that are driven by very different factors. For example, the Russian equity market is heavily concentrated in energy, while Taiwan has high exposure to information technology. Emerging markets also have high variability in their level of political risk, the stability of their currencies and many other important factors. These differences tend to translate into very large variances in equity market performance across countries.
Figure 2 depicts total returns over several time periods for the 20 emerging markets included in the S&P Emerging BMI in descending order by index weight. Historical performance clearly indicates substantial performance differentials across countries. Even if we focus on only the largest five countries, we see enormous return variation. For example, year-to-date through Sept. 30, 2012, India gained 24.0 percent as the market recovered from a sharp 37 percent decline in 2011, driven by concerns over the country’s economic and financial market regulations. Over the same period, Brazil declined 1.2 percent as investor sentiment turned negative about the country’s growth prospects; and sectors that dominate the Brazilian equity market, such as energy and materials, lagged. Over the long term, we also see very large performance differentials. For example, Brazil has returned an annualized 32.1 percent over 10 years, while Taiwan has seen a comparatively meager 10 percent total return per annum.