Emerging grey area
Joseph Mariathasan finds ‘emerging markets’ to be a legacy concept that has become increasingly blurred and illogical
At a glance
• There are strong arguments to question the current framework for classifying emerging markets.
• The asset class is highly heterogeneous.
• It is difficult to define the boundary between emerging and developed markets.
• Some argue it would be better if the term ‘emerging markets’ was abolished.
Is it time to move beyond the idea of emerging markets as a separate asset class? China and arguably India have become too important to be lumped with 40 other developing economies. China alone is having such a substantial impact on the global economy that it is arguably a more important country to have a view on than Japan, which for many institutions has long been a separate investment destination. “I would say that institutional investors should have mandates to invest in India and China in the same way they have mandates to invest in the US or the UK,” says the economist Jerome Booth.
There are strong arguments for suggesting that the current framework for treating emerging markets is not ideal. “It has been appropriate for years to think about whether individual emerging markets should be regarded in a separate way. There is no real logic in lumping Korea and Brazil together. You can see the huge differences in correlations between markets, income levels and so on,” says Tapan Datta, global head of asset allocation at Aon Hewitt.
Moreover, as Erik van Dijk, the chief investment officer at LMG Emerge, points out, the line between the less developed of the developed markets and the more developed of the emerging markets is blurred. Greece is the obvious example: “As a portfolio investor following a diversified strategy, we believe that the moment where both China and Japan should always be the backbone of the Asia component of the global strategy, and Asia as such a region that one cannot bring down to a zero weight anymore, is already there,” says van Dijk.
But shifting away from the current framework is not so easy. “We are all prisoners of benchmark legacies,” says Datta. As he points out, the various benchmarks have some oddities in their criteria for classifying emerging markets as against developed markets. “The whole edifice has been bolted together around the ways portfolios have been constructed, particularly around the US,” he says. “There, the move was from the US to developed markets outside the US, that is, EAFE [Europe and the Far East], with everything else lumped together as emerging markets.”
Booth agrees. “Emerging markets are highly heterogeneous. The interesting thing, therefore, is not what binds them and never has been. Emerging markets were never a coherent group of countries. The term arose from a definition of ‘other’ rather than a definition of common characteristics.” That definition of ‘other’ is still as valid as it ever was, says Booth, which is why he would say it should be kept for the time being.
Aon Hewitt does not see much demand for separate country strategies for listed equities and it is not something that they would generally advocate, explains Datta: “Our favoured model has been global emerging, given the intrinsic volatility and risk. You need the diversification that is intrinsic to a big opportunity set and you don’t want to take huge amounts of single country risk.”
There are, however, situations where managers can have a tactical exposure for a few years. So if they really thought India showed exceptional opportunities they could hold extra amounts above the benchmark weight.
The bigger question is what constitutes an emerging market and what does not, says Datta. For Booth, the problem is that institutional investors not only have a home bias but also a foreign bias, in that, when they invest in countries abroad, they prefer countries exactly like their own.
“The whole point about emerging markets is what it is ‘other to’,” says Booth. The dividing line between emerging markets and developed today is still about prejudice. We have a prejudice that everything in the developed world is safe, and everything in emerging markets is risky. And that is what defines emerging markets.”
He also says, controversially, that “some of us argue that actually emerging markets are not always intrinsically more risky. But let’s not forget why we call them emerging markets. It is not because we are thinking in a logical structured way, it is because we are not thinking.”
Booth argues that emerging markets are part of the ‘other world’ where risk is perceived properly and priced in accordingly as against the developed world where it is not. “The day that we can get rid of the term emerging markets is the day that sovereign risk is properly priced in the developed world – the day that investing in the developed world is not just a set of knee-jerk reactions that ignore macroeconomic imbalances,” says Booth. Whether you agree with him or not, it does look as though emerging markets as a separate asset class concept will be around for some time to come.