Emerging markets have become well ensconced in the minds of equities investors and an inextricable part of the global economy. In 1988, at the inception of the MSCI emerging-markets (EM) index, the ten countries listed at the time represented less than 1 percent of the MSCI All Country World index. As of October 2013 the EM index covers 800 securities in 21 nations identified as emerging markets and comprises some 13 percent of global market capitalization.
Usually, investors will develop their emerging-markets strategy by taking a survey of cap-weighted market indexes such as the aforementioned MSCI EM index. Because the indexes are illustrative of the market portfolio as a whole, managers can look to them as a basis for passively managed index funds and exchange-traded funds or as benchmarks for actively managed strategies. Such an overview also allows analysts and investors to assess emerging-markets volatility in an accessible and cost-effective manner.
Active managers should primarily focus on the relevant benchmark index portfolio, as the securities in play can be judged relative to the market-cap weight of the security in the index. From the fund manager’s viewpoint, the index portfolio is its minimum-risk portfolio. Because the index portfolio is rules-based and takes relatively little effort to build, the value that an active manager adds can easily be assessed by comparing the performance of the active strategy with its market index benchmark.
The downside to the popularity of cap-weighted indexes is that their use has gone beyond simply measuring the performance of an asset class. While cap-weighted indexes have a number of flaws that come to the fore when analyzing emerging markets, there are justifiable reasons why managers still refer to them. When institutional investors first decided to allocate assets to a perceived high-risk and esoteric asset class, they needed simple benchmarks for performance comparisons. But the amount of money invested was just too small to make it worthwhile to split exposure among countries and regions for different actively managed funds.
It could be argued that these cap-weighted indexes have more to do with ensuring liquidity than with coverage, a consideration that can be taken into account when investing in highly volatile asset classes. Given the still relatively low weight of emerging-markets equities in most plans, achieving maximum diversification within an asset class would be less relevant should the total exposure be only 5 percent or less of a plan’s assets.
Emerging-markets index funds have provided investors with new avenues for return on emerging-markets beta, both as segregated mandates and, increasingly, through ETFs. Emerging-markets ETFs have seen huge inflows during the recovery from the recent recession as investors used them to gain rapid exposure to a high-demand asset class. Recently, these funds have also seen huge outflows during the risk-off cycle . But even ETFs covering large-cap emerging-markets stocks face liquidity issues. Independent of valuation and liquidity, regular rebalancing is necessary as stocks flow in and out of the relevant index to which the ETF is benchmarked. That in itself gives rise to turnover and associated transaction and market impact costs.
An analysis of cumulative returns since April 2003 shows that over a rolling three-year period, even passive investing has underperformed the EM index, illustrative of the inefficiencies inherent in emerging markets. For example, the iShares emerging-markets index ETF underperformed the EM index by a cumulative 25 percentage points between April 30, 2003, and December 31, 2012.
What are the limitations of traditional index-based approaches to EM investing? In Investec’s experience, the flow of investment capital tends to be heavily skewed toward the seven largest emerging markets — Brazil, China, Russia, India, Korea, South Africa and Taiwan— which collectively account for approximately 80 percent of the present 21-country MSCI EM index. The remaining 14 countries receive little dedicated investment, in comparison. These arguably narrow-minded market-cap-based approaches can be detrimental to institutional investment, fail to deliver on either diversification or consistent long-term capital appreciation and concentrate exposure in a handful of countries — namely, those in the MSCI EM or the MSCI frontier market (FM) indexes. It should be noted that starting in November, MSCI is listing Morocco in its FM index, moving the country down from its previous classification in the EM index. Also next month Greece is moving to the EM index from developed-market status. Qatar and the United Arab Emirates are moving up to the EM index from the FM index next May.
There are economies that fall outside the parameters of the convenient labels afforded by these market indexes, and we believe such countries will be next on the investment horizon. They constitute smaller emerging markets and frontier markets, including many in sub-Saharan Africa, that are underrepresented, poorly understood, inadequately researched and thus, in many cases, excluded from investment. Used to complement existing investments in larger emerging markets, these smaller emerging markets may offer investors a fresh perspective on their pools allocated to developing markets.
Our research has identified 40 of what we have termed “horizon markets,” a group that excludes the seven largest emerging markets. Given their history of risk and return, these smaller emerging and frontier markets may give investors a chance to take their emerging-markets strategy beyond the countries listed on the indexes. Focusing on these smaller emerging markets, to complement existing allocations to large emerging markets, may offer investors a fresh perspective on developing markets that goes beyond tidy classifications.
Kemal Ahmed is a portfolio manager with Investec’s frontier and emerging-market equities team.
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