Emerging markets, and their trade relationships with one another and the rest of the world, are changing. Traditional investment frameworks are struggling to remain relevant, writes Joseph Mariathasan

Zhiwu Chen, professor of finance at the Yale School of Management and chief adviser to the fund of hedge funds, Permal Group, likes to show a graph that plots the GDP of most countries in the world against population size for the past 1,000 years or so. China had 40% of the world's population 300 years ago - and accounted for roughly the same proportion of global GDP. India was comparable. Indeed, up to around 1820, the correlation between GDP and population size was close to 100% wherever one looked.

It was ‘all change', of course, with the advent of the industrial revolution, which massively increased the GDP of what we now know as the developed nations. That correlation reached a low of about 35% around 1970.

But, since then, it has rebounded - and the post-Cold War trend is clearly evident. Highly mobile industries, such as textiles, were free to chase the cheapest producers as huge labour markets opened up and the rules-based international order of the World Trade Organisation (WTO) replaced the guns-and-boats regime that shaped global wealth creation from the sixteenth to the nineteenth centuries. The East India Company had its own armed forces, larger than those of the country (the UK) where it was domiciled. In today's world, argues Professor Chen, the nearest comparison would be GE: it deploys an army - but of lawyers, not soldiers.

"Rather than focusing on exports from the developing world, multi-lateral organisations focused on opening emerging markets to increased competition and breaking down import tariffs," explains Kemal Ahmed, a portfolio manager at Investec Asset Management. "The gains to these countries come not only from the reduction of trade barriers, but also from policy commitments focused on liberalising large segments of the economy. For institutional investors this means that as economic opportunity migrates, these markets are moving from an opportunistic allocation to a core component of an institutional investment plan."

Identifying such a major theme is simple, but implementing it - particularly in a global-investing context - is surprisingly challenging. Many institutional investors enjoy well-established relationships with fund managers running global equity mandates that have some flexibility to invest in emerging markets. But as Deb Clarke, head of emerging market research at Mercer points out, many institutional global equity funds still use the MSCI World index, which does not include any emerging markets, as their benchmark. Exposures, therefore, tend to be stuck under 5%.

As a first step, she advocates a move to the MSCI All Countries World index (MSCI ACWI), which currently weights emerging markets at around 12%. Moreover, Mercer's advice is to be overweight, which could lead to weightings of as much as 20% or more. That would require a complete reassessment of their approach to investment. Perhaps even the term ‘emerging markets', used to represent a separate asset class, should be regarded as defunct.

Some prefer ‘growth markets' but even that preserves the idea that 60 or more separate markets, representing well over 50% of the human race, can be meaningfully lumped together. Add in the fact that their weightings in benchmarks tend to be based on historic market capitalisation of their stock markets - concentrating exposure in a handful of countries - and the idea is even less supportable. No one would make a long-term, institutional-sized allocation to the US equity market based on the Russell Top 50 index rather than the S&P 500. And yet 80% of the market cap of the MSCI Emerging Markets index is accounted for by the BRICs, Korea, Taiwan and South Africa, within which only the largest and most liquid company stocks are represented.

"Institutional investors are under-served in gaining exposure to this critical investment opportunity of rising incomes within the emerging and frontier markets," says Ahmed. "Increasingly, the difference is less between ‘emerging' and ‘frontier' markets, as between large emerging markets and all other emerging and frontier markets. We contend that an entire investable universe of smaller markets exists that is under-represented, poorly understood, inadequately researched and, in many cases, excluded from investment."

A sensible solution could be to allocate a proportion to dedicated large emerging markets strategies and the rest invested in a global strategy focused on the smaller emerging and frontier countries. These, as a whole, have an economic importance much higher than their market capitalisation would suggest. Moreover, the greater focus on domestic consumption in these markets means that they are less susceptible to the impact of declining GDP growth in the developing world, but also exhibit modest correlation with developed, large emerging and even other small emerging markets.

"What is also striking is that the smaller emerging markets and frontier markets universe has, over a 10-year period, experienced higher returns and lower volatility than either the MSCI EM or FM indices," says Ahmed.

Ultimately, investors in emerging markets have three broad choices of companies: exporters of manufactured goods to the developed world, which are dependent on the health of the developed world for their growth; exporters of commodities, often to other emerging markets; and companies servicing domestic demand. In the current global environment, domestic demand looks the most promising.

This theme, of course, can be approached in many ways - including investing in US or European stocks with high revenue exposure to emerging markets. But as Arjun Divecha, chairman of GMO and head of its emerging markets strategies argues, there are few multinational companies that derive a substantial part of their revenue or income from emerging markets. In fact, most multinationals do not represent a ‘pure play' on emerging domestic demand. Moreover, locally-domiciled companies in emerging markets currently have substantial home-field advantage.

"These advantages include high barriers to entry, the expenses associated with building brand awareness relative to well-established local brands, government policies that tend to favour locals, and the fact that local competitors are likely to have high profitability and substantial economies of scale that make it easy for them to defend - rather than build - their market share," says Divecha.

GMO recently launched a strategy which it sees as a complementary emerging markets investment opportunity, focusing on local companies servicing domestic demand. It explicitly targets specific sectors that look attractive to a value-oriented manager. This invariably means selecting specific combinations of countries and sectors where profitability is high.

"At the country level," says Divecha, "large populations that are in the sweet spot of consumption growth - such as India, Indonesia, Brazil, China - are more attractive than countries that are already relatively developed - such as Korea, Taiwan, Israel."

Similarly, not all sectors within these countries are attractive: "In India, telecoms may be seeing fast growth, but there are 15 players, so it is hard for anyone to make sustained profits. In contrast, in China there are only two or three telecoms players. In Brazil, the utilities are interesting, which is not the case in many other countries. Within these countries and sectors, companies that have a proven franchise that will allow them to command high profitability in the face of non-linear demand increases are most attractive. Profitability, brand, franchise, supply chain, and experience matter."

Inevitably, this often speaks to company size as well as country size - an obvious route for diversification, given the dominance of larger-cap stocks in the MSCI indices. But adopting a qualitative approach to selecting smaller-caps in emerging markets across the globe is a Herculean task that few managers can do successfully. Mercer, according to Clarke, has seen very few offering global emerging market small-cap strategies: "The huge number of companies makes it very difficult for fundamental managers. Global small-cap is tough to do. Emerging market small-cap is even more difficult." Capacity will continue to be a challenge: with between $1-2bn seen as the maximum fund managers expect to be able to manage, the total capacity in the market place for dedicated small-cap mandates is very limited.

One route forward in the small-cap sector is to adopt a quantitative approach. Accounting standards in emerging markets have been generally improving for some years now, to the extent that many successful quantitative fund managers have been able to adapt their existing models to exploit them. In a universe of 20 or more highly disparate countries, quantitative analysis as a basis for fund management approaches gives the ability to adopt a consistent analysis across a whole universe. This is particularly valuable in the small-cap arena, where the number of companies is so large.

Fraser Hedgley, global emerging markets product specialist at Nomura Asset Management, explains that its process starts with the entire universe of emerging market stocks before excluding only the 800 or so companies in the standard indices, and non-index large-cap names, leaving a universe of 5,000 names. Screening out illiquid names and stocks with market capitalisations less than $50m still leaves 3,200 names to consider. This is essentially the universe that an active quant process can be applied to.

Most fund managers would agree with Divecha who argues that the key in emerging markets is to look for fast-growing country and sector combinations where the nature of competition is such that it allows for players to have high profitability. For institutional investors that want seriously to increase their exposures to emerging markets, it requires seeking complementary approaches to the MSCI-dominated portfolios that characterise their current exposures. Understanding the alternatives on offer and engaging in a dialogue with those managers on the cutting edge of thought leadership in emerging markets will become of increasing importance.