Rethinking Emerging Markets With ‘Building Blocks’

Oleg Ruban and Anil Rao of MSCI discuss how investors are taking a new approach to emerging markets.

Reviewed by: Lisa Barr
Edited by: Staff

Emerging markets (EM) are often misunderstood, regarded as a large, monolithic bloc with transitioning economies that react to geopolitical and demographic forces in fundamentally the same ways.

But these markets have taken very divergent paths in response to the recent acceleration in deglobalization and other major shifts, resulting in a greater dispersion of returns among countries.

So what does this mean for institutional investors trying to detect new opportunities in EM? For some, it has meant taking a more nuanced approach—building strategies based on smaller, “geographical blocs” to allocate to these markets.

Investors may benefit from rethinking their EM allocation approach, particularly as China has complicated the deglobalization picture with its postpandemic economic reopening. And geopolitical tensions seem to have intensified deglobalization.

The approach, however, is not without challenges. It requires a deeper look at risk and return drivers and a more complex set of asset allocation decisions, allowing for greater flexibility and diversification.


From Emerging to Diverging

A number of global changes have impacted EM stocks recently. The surging U.S. dollar and China’s growth slowdown weighed on EM returns in 2022. The MSCI China Index also declined by nearly 22% last year, as markets were hit with China’s zero-COVID-19 policies, struggling real estate and technology sectors, and headlines from the 20th National Congress of the Chinese Communist Party.

Additionally, the adage of “higher risk, higher return” has not held true in EM throughout the COVID-19 era, as indicated by the EM country performance chart below. Countries beset with persistent inflation and political unrest, such as Brazil and Turkey, fell sharply. In contrast, Asian manufacturers in Taiwan, India and Indonesia fared relatively well. All of the Asia ex-China countries, designated by the blue circles, comprised the largest bloc by market capitalization in EM as of December. 

EM Country Performance During Pandemic

Source: MSCI   
Returns are gross in USD from January 2020 through September 2022. Larger circle sizes indicate larger country weights.

MSCI found that this bloc’s performance has stood up longer term as well, as indicated by the Asia ex-China return chart below, with help from the West’s deepening ties with India’s manufacturers and Taiwan’s semiconductor industry. Even domestic Chinese A shares, with their tilt toward consumer staples and industrials, have been more resilient than their technology-heavy, overseas-listed counterparts.

Asia ex-China Return Following 2008 Global Financial Crisis and During Pandemic

Source: MSCI    
Returns are gross in USD from January 2011 through December 2019, and January 2020 through September 2022. 

We can see from the cross-sectional volatility (CSV) chart below the dispersion of performance driven by the country of exposure, with the country portion of cross-sectional volatility reaching historic highs in EM in 2022. This suggests EM is more appropriately viewed as a diverse group of regional blocs, some of which have been resilient over the past decade. For investors, this means a regional approach could be beneficial, identifying potential pockets of opportunity through nuanced and targeted EM allocations.

Cross-Sectional Volatility in MSCI Emerging Markets Index

Data as of December 31, 2022 

Building With Regional Blocs

There are a number of ways to react to this dispersion. Investors are considering, for example, distinct allocations to China and EM ex-China.1 By separating China, the largest EM country, allocators are aiming to manage country risk by assembling a more diverse EM portfolio.

EM ex-China includes countries with diverse economic fundamentals, industrial structures and varied exposures to market and geopolitical risks. However, the segregation of China may not provide enough flexibility in allocation decisions or achieve greater diversification.

Investors also could focus on individual countries as the macro portfolio building blocks. But while this level of granularity may provide ample opportunity for distinction and diversification, it may not be feasible for investors who lack the resources to make allocation decisions for the 24 countries in the MSCI Emerging Markets Index.

MSCI considered how to remain flexible to achieve diversification benefits, while maintaining reasonable simplicity. We looked at how the risk/return trade-offs would change when investors replaced a broad EM allocation with just one allocation decision, with options to allocate to:

  1. China and EM ex China (two allocation decisions)
  2. Five geographic blocs (five allocation decisions)
  3. Individual EM countries (24 allocation decisions)

The first two options present a mild increase in decision-making complexity, while the third presents a significant increase in asset allocation decision complexity. Below we map countries to the blocks selected for option two, with countries within each block weighted by their market capitalizations.

Country Weights Within Regional Blocs

As of Jan. 31, 2023. 

Finding the Efficient Frontier

We constructed efficient frontiers for the three options, using the covariance matrix from the MSCI Global Equity Factor Model and expected returns that assume an equal Sharpe ratio across all EM countries as shown in the efficient frontiers chart below.2 The MSCI Emerging Market Index is on the efficient frontier formed by MSCI China and MSCI EM ex China indexes.3

Moving from one allocation decision to two provides enhanced portfolio-positioning flexibility with a greater choice of levels of risk and return. However, if investors take on the risk of the MSCI EM Index,4 they would still have to accept the same expected return as the EM index.

Moving to option three would involve ramping up the number of decisions from one to 24, but it could potentially enhance the risk/return trade-off. Under our assumptions, for the same expected return as the EM index, the forecasted risk would be reduced from 18.8% to 14%. The cost, however, is a significant increase in decision-making complexity.

Option two, however, provides a middle ground. Under our assumptions, for the same expected return as the EM index, the forecast risk could be reduced from 18.8% to 16.1% at a cost of only a mild increase in decision-making complexity. The practical implication is that using blocs of similar countries can help allocators gain diversification benefits and create more allocation opportunities, while limiting the decision-making complexity.

Efficient Frontiers of EM Allocations

Data as of Jan 31, 2023. 

Achieving Greater Flexibility and Diversification

So the question we ask is, considering the need for some institutional investors to construct more nuanced allocations to EM, is it possible to construct an approach that offers greater flexibility and greater potential diversification benefits, while preserving parsimony?

Selecting five geographical blocs of EM countries with similar return attributes may allow for the construction of a more flexible allocation to EM without decision-making at the individual-country level. We believe a similar approach could be applied to developed-market equities and fixed income markets, which have also been impacted by deglobalization.

Ultimately, these economies have evolved in different ways and grown at different speeds as they react to deglobalization and other major global shifts. Allocation strategies based on macro perspectives have become less relevant. Investors may benefit from rethinking those strategies in this deglobalizing world. Detecting new opportunities may require a more granular approach, constructing efficient frontiers for various nuanced allocation options.


Oleg Ruban is Executive Director and Head of APAC Equity Solutions, MSCI
Anil Rao is Executive Director, Equity Solutions Research, MSCI

1 Asset allocation decisions can vary significantly from market-classification decisions. Simply, asset allocation aims to identify opportunities for differentiated returns, while market classification reflects institutional investors’ experiences of market accessibility and economic development.

2 Our aim is to show the potential for diversification, rather than forecast expected returns. We made an assumption that a unit of risk taken in each country’s equity market is equally rewarded with expected return. We assumed an expected Sharpe ratio of 0.2 for each EM country, and used the forecasted risk of the MSCI country index to back out an expected return. The forecast risk was obtained from the MSCI Global Equity Factor Model. The value of 0.2 is close to the historical cross-sectional mean across EM countries over the past 20 years. As long as a positive Sharpe ratio is assumed, its level does not impact the conclusions.

3 This is always the case, as EM is a linear combination of EM ex-China and China.

4 18.8% as of Jan. 31, 2023.

MSCI is a leading provider of critical decision support tools and services for the global investment community. With over 50 years of expertise in research, data and technology, we power better investment decisions by enabling clients to understand and analyze key drivers of risk and return, and confidently build more effective portfolios. We create industry-leading research-enhanced solutions that clients use to gain insight into and improve transparency across the investment process.