The Emerging Markets Debacle

“How much did the iShares MSCI Emerging Markets ETF (EEM) return during the nearly 16-year stretch from Nov. 1, 2007 to May 19, 2023?” asked Nate Geraci, president of The ETF Store.  

The answer? Zero.  

So began the panel on emerging markets and China at the Inside ETFs conference in Hollywood, Florida. 

That lousy performance—which compares to a 275% gain for the S&P 500 in the same period—underlines the frustration and disappointment investors in emerging market stocks have felt since the global financial crisis, and it colored much of the discussion that Geraci had with Brenden Ahern, chief investment officer at KraneShares. 

“What I’m hearing from advisors is that they’re throwing in the towel on emerging markets. They’re either reducing their allocation to EM or they’re bringing it all the way down to zero. They just can’t take the pain,” said Geraci. 

Ahern acknowledged that emerging market investors have felt pain:  

“From 2009 to 2023—that’s 56 quarterly investment committee meetings or meetings with your clients explaining why you’re diversifying into an asset class that’s underperforming so significantly.” 

For Ahern, much of EM’s underperformance can be attributed to the way in which the broad emerging market indexes are structured.  
 
“The indexes don’t capture the growth of emerging markets such as China,” he said. 

Ahern noted that 10 years ago, the energy and financials sectors accounted for 50% of the MSCI Emerging Markets Index and the MSCI China Index. 

So when growth sectors like technology took off over the next decade, those indexes naturally underperformed more tech-heavy benchmarks like the S&P 500. 
 
“You [went] into the greatest decade of growth investing, and these two benchmarks [were] basically value proxies,” Ahern said. 

But the stellar performance of tech wasn’t exclusively a U.S. phenomenon. 

Ahern said that the tech sector within the Emerging Markets Index has beaten the S&P 500’s return since the bottom of the global financial crisis. The problem is that tech only represented 11% of the EM index during that run.  

To compensate for this, Ahern recommends that investors “dial up that growth element within their EM or China allocations” using ETFs like the KraneShares CSI China Internet ETF (KWEB). 

China Risks  

Much of the rest of the discussion focused on China and how Ahern thinks many investors are misguided in their belief that the country is too risky to invest in. 

Four of the five concerns that investors have had about investing in China have abated, Ahern explained. Zero COVID-19, delisting risk, the internet crackdown and the real estate downturn are no longer holding China stocks back, in his view. 
 
On the other hand, the geopolitical situation surrounding China’s relationship with Taiwan remains an area to watch, though Ahern stressed that he doesn’t view China-Taiwan as analogous to Russia-Ukraine.  

Another interesting point that Ahern made is that investing in U.S. stocks exclusively still comes with plenty of China exposure. He said that roughly $500 billion of Apple’s market cap comes from China— “more money than all U.S. mutual funds and ETFs invested in China.” 

“You are highly exposed to China implicitly through U.S. multinationals,” Ahern explained.  

Whether that means investors should double down on their China exposure through allocations to broad emerging market ETFs or China-focused ETFs is more debatable. 

Ahern made no secret of the fact that he’s bullish on emerging markets, and China in particular. He suggests investors keep exposure to broad EM, but dial up their exposure to mainland China—and particularly internet and e-commerce stocks within mainland China—because that’s where the growth is. 

Ultimately, Ahern made some solid arguments, but after 16 years of underperformance and geopolitical risks still front and center, it will be challenging to change peoples’ minds about investing in emerging markets.  
 
Geraci, who is an investment advisor, summed up both sides of the argument nicely: “It’s been difficult over the past decade-plus. If you’ve built a diversified portfolio, you have had to have conversations with clients about the underperformance there. On the other hand, if you’re not going to invest in emerging markets or in China … you’re [staying] away from what’s now the world’s second largest economy, [and] you’re also making an implicit bet there.” 

Geraci concluded that “the best portfolio for the client is one they can stick to.” 
 
If advisors can provide education about why they are holding positions in China or broader emerging markets, then an allocation “might make sense” as long as “the client can stick with it and let that develop over multiple cycles.” 
 
“[But] it’s easier said than done,” admitted Geraci. 

Contact Sumit Roy at [email protected]