In the late eighties, a small group of institutional investors started to look beyond traditional equity markets to invest in emerging markets.  assess the development of this distinct asset class.

These early investors had a very simple yet powerful rationale for investing in these markets. They postulated that they would benefit from rapid economic growth if they invested in markets that were at an early stage of development and had considerable potential for further development. They anticipated that developing countries would progressively adopt market-oriented policies in a globalizing world and that they could invest in companies at low valuation, as these markets were under researched and undiscovered.

Indeed, the last twenty years have seen a continuously expanding universe due to the opening of previously closed markets or markets reaching sufficient size and liquidity to become investable.

For example, since the MSCI Emerging Markets Index was introduced in 1988, the weight of emerging markets in the MSCI All Country World Index (ACWI) has grown from less than 1% to 12%.

The combination of the desire for and achievement of economic growth and the willingness to open the investment opportunities to non-locals has led to more markets joining the international investment opportunity set. The latest entrants are markets from countries in the Persian Gulf, the Balkans, and sub-Saharan Africa.  On the demand side, investors continue to seek new investment opportunities and show interest in investing in these ‘frontier’ markets, which are typically smaller, and have fewer and smaller companies that are less liquid.

These new potential investment opportunities are sizeable, representing as much as 20% of the current emerging and frontier markets universe. These new segments can be broken down into closed markets that might potentially open such as Saudi Arabia and the China domestic market (A shares), and frontier markets that are open but still relatively difficult to access. Reinforcing the constantly evolving nature of financial markets, MSCI Barra recently announced that it would reclassify Jordan as Frontier Market and would be consulting on proposals to reclassify Israel and Korea as Developed Markets, and on proposals to reclassify Kuwait, Qatar, and the UAE as Emerging Markets.

Obviously, economic growth potential does not necessarily translate into realized growth. However, in the aggregate, emerging markets have indeed experienced higher economic growth rates than developed markets. The average economic growth rate has been a full percentage point higher for emerging markets - 5.9% annually over the last 20 years compared to 4.9% for developed markets.

However, the aggregate number alone does not provide the full picture. Growth has not been uniform across all emerging markets.  In 1987, Argentina and Korea had similar GDP per capita at around USD 3,000. At the end of 2007, Korea’s GDP per capita was three times that of Argentina.

It is also interesting to note that the divide between high growth and low growth is not exclusively along the lines of emerging and developed countries. Ireland, a developed market country, is in the fastest growing category and four of the five slowest growing countries are emerging markets.

Not only are growth rates not uniform across emerging markets, the growth is subject to violent disruptions. For example, during the 1998 crisis, the weight of emerging markets in the MSCI All Country World Index dropped from 8% to 4%.

How do Economies Grow?

It is not clear that there is a beaten path to achieving economic growth. One model that appears to have produced sustainable levels of development is based on manufacturing. Most of the current developed economies of the world grew through industrialization and manufacturing growth. The development of Japan post WWII was based on manufacturing excellence. Korea applied a similar model roughly 20 years later. China’s recent growth has been based on the same roadmap. These countries have policies explicitly targeting growth and have built strong political and social consensus around the necessity to support growth. Very often, high levels of investments needed to support this growth are funded by large domestic savings and complemented by select Foreign Direct Investments.

Japan’s GDP per capita series has been moved forward by 40 years and Korea’s by 20 years in this chart. It is striking to see how closely Korea has been tracking the time-shifted growth path of Japan and how China may be able to achieve similar or stronger rates of growth.

The development model of the other BRIC countries seems to have different drivers, much more influenced by natural resources in the case of Russia and Brazil, while India is testing its own version of economic development with a strong component of outsourced services. This new dimension of growth in services rather than manufacturing has been made possible by the advent of the internet and the huge reduction in communication costs linked to it. These new models for growth have been untested over long periods but may prove to be other pathways for achieving growth.

When looking at risk and return over rolling 5 year periods, it is clear that, collectively, emerging markets have shown a consistent pattern of higher volatility compared to developed markets.

 During the late 1980s and 1990s, returns varied significantly across emerging markets and the monthly return range of the best and worst performing country indices exceeded 80% on a regular basis. Even in August 1998, not all countries went negative; Morocco and Pakistan posted positive monthly returns of 7% and 5%, respectively.

During the 2000s, the range of index returns has come down, confirming the relative absence of major economic or political crises within Emerging Markets in recent years. Country specific extreme events may have happened less frequently in the recent past but the market as a whole has continued to experience monthly returns above/below +/- 10%.

In addition, average country correlations across emerging markets have increased over the last 20 years from a low of 5% to more than 46% in the most recent 60 month period. The average correlation across the BRIC countries has moved even higher to 55% in the recent period. These results indicate that emerging countries have recently become more interdependent, potentially leading to fewer diversification benefits at the country level.

Most aspects of our analysis so far highlight the importance of the economic and political environment in emerging markets. Is it possible to quantify the relative importance of the country return relative to global sector and style factors? Has there been a trend towards sector diversification and importance within emerging markets similar to developed markets, and in particular Western Europe? Or is the country still the main driver of equity risk and returns?

Due to the pioneering work of Barr Rosenberg in the late 1970s, we know that equity returns are influenced by systematic or fundamental factors. These factors are typically grouped into countries, sectors and styles, such as the market capitalization of a company, the value characteristics or recent price momentum. We can measure the relative importance of these fundamental factors by looking at the cross sectional volatility of stocks across markets through time and by looking at how much of the return dispersion as explained by the fundamental factors comes from country, sector or style factors.

Whilst of equal importance to sectors in Developed Markets, the country factor has been a dominant factor in explaining the cross sectional volatility in Emerging Markets.

The importance of the country factor as a driver of stock returns, and the divergence between economic size and market size of countries that are also potentially the faster growing economies, explains the potential interest  for an alternative weighting approach - based on the economic weight of countries rather than market capitalization. Recently there has been increased interest in alternative weighting schemes designed to bias portfolios towards a desired factor. For example, equal weighting is one way to tilt a portfolio towards smaller stocks and capture the size factor. Similarly, fundamental weighting tilts portfolios towards value stocks.

It is, therefore, interesting to look back at one of the first alternative weighting schemes, the GDP-weighted index. MSCI GDP-weighted Indices were introduced in 1988 to address the issue of the large weight of Japan in the MSCI World Index. The GDP weighting scheme was extended to cover Emerging Markets and MSCI ACWI in 2005. GDP-weighted indices use the country’s GDP as the weighting factor instead of market capitalization. Consequently, the weights of countries in the GDP-weighted index will represent the relative importance of a country’s economy as opposed to the size of its equity market.

The largest current over-weights in the MSCI GDP-weighted ACWI Index are for Emerging Markets, such as China, India and Russia, which are some of the fastest growing economies but have market capitalization weights that are relatively smaller than their economic weights. While the overweight list includes some developed markets, such as Germany and Italy, the countries with the largest disparities in terms of their market capitalization weights being larger than their economic weight are the US and the UK.

These built-in differences in country weights produce an interesting risk return profile, as shown in the chart below. It is striking to see that a simple concept such as GDP-weighting has been so effective at capturing the two major shifts in asset allocation over the last 20 years: underweighting Japan in the 1990s and overweighting Emerging Markets since 2005.

There has been little study on why a GDP-weighting scheme may be a more effective way to allocate across countries. As always, one possible explanation is that its apparent effectiveness is purely accidental. Another one is that the GDP weight would serve as a better proxy of the natural country weight - including unlisted equities - in the global portfolio. Another more tactical explanation is that GDP weighting is a way to anticipate other investors’ asset allocation decisions, therefore buying before everybody else buys and selling before the others sell.


Our review of 20 years of emerging markets history shows that economic development and market openness play a significant role in the entrance of and growth of markets into the international investment opportunity set.  Just as long-term economic growth reshapes the relative importance of nations, rapid and unsustainable economic expansion can also lead to macroeconomic imbalances and create periods of disruption as was seen in the crises in the 1990s. This historical perspective highlights the importance of the country factor in emerging markets investing.

In that context, index providers have also evolved in their role of supporting international investors accessing these markets, by reflecting the expanded opportunity set on a timely basis, by managing the evolution of markets in the context of their country classification as frontier, emerging and developed and also by providing alternative views and tools to capture the country factor such as GDP-weighted indices.