For institutional investors, investing in emerging markets is a true test of fiduciary duty. The asset class – if it can be defined as such – has enormous potential, yet it is also risky, not just in terms of volatility but also of reputation.
The share of global GDP, in purchasing power parity (PPP) terms, of emerging markets and developing economies has grown from 43% in 2000 to 58% this year, according to the International Monetary Fund (IMF). Barring a few notable exceptions such as China, Taiwan, Korea, South Africa and Brazil, most countries are underrepresented in the MSCI Emerging Markets index compared with their share of GDP.
Investment flows from developed countries to emerging market countries are extremely volatile, which explains the volatile performance of emerging market stock and bond indices, and to some extent also the volatility of their economic performance. This year investors seem bullish on emerging markets, judging by the rebound of the MSCI EM. The reopening of China and the improving economic prospects outweigh the pressures of global inflation and unstable geopolitics.
However, investors are under-invested in emerging markets. A 2022 study by BlackRock found that the optimal emerging markets allocation in a global portfolio, determined using various fundamental economic and market-based methods, was well above what most allocators currently held at the time.
The opportunity cost of investing in emerging markets is high, but investors often choose to forgo the opportunity. This can be because being perceived to over-allocate to emerging market assets could be seen as reckless. Or it could be because building an appropriate allocation requires a level of experience and a capacity for due diligence that most investors do not have.
Corporate governance-related troubles, such as the Adani scandal in India, are a reminder of the challenge of investing in emerging markets, but as our emerging markets report shows, corporate governance is improving, and there are many opportunities to invest within developed market standards.
The strategic questions surrounding emerging market investing include whether to build a diversified or more concentrated portfolio and whether to employ local or international managers. But an investor’s overarching strategy should be to build an optimal allocation to emerging markets, which is likely to be higher than many investors currently hold.
This is a crucial. Emerging markets will become increasingly integrated in the global economy and therefore investors that miss out on their growth are potentially neglecting their fiduciary duty. At the same time, there is much to be gained from focusing on responsible investment questions in emerging markets. These markets offer the greatest potential for investors to contribute to a more sustainable future, given their development needs with a specific focus on the requirement to modernise their energy production.
Right on the doorstep of Europe is an emerging market country, Ukraine, whose existence has been threatened and that will require a huge amount of impact-focused investment. This and most other kinds of emerging market investment are truly long-term in nature, which is a necessary component of modern institutional investment practice.
Carlo Svaluto Moreolo, Deputy Editor