MSCI in a recent note raised the issue as to whether it is time investors re-examined their approaches to investing in emerging markets.
Raman Aylur Subramanian of MSCI’s equity applied research team makes the point that institutional investors face at least three choices in their allocations to emerging markets. They can allocate to an integrated, global equity approach (active or passive). They can adopt a dedicated emerging markets allocation. Or they can make active allocations to particular countries within emerging markets.
There is a long-term structural change in the world which can be seen as the narrowing of the arbitrage between emerging markets and developed. There are many different manifestations of this, including the rise of the domestic consumer within emerging markets, and the increasing role of trade flows within emerging markets, compared with trade flows between emerging markets and developed.
Then there is what MSCI themselves raise in Subramaniam’s article, namely the convergence of return and risk profiles between developed and emerging markets. Combined with the dispersion between countries within emerging economies, this means that some institutional investors are reconfiguring mandates to take more active views on individual countries.
This acknowledges that most dispersion between emerging market stock returns is due to country factors. It has certainly been true in the past that one characteristic of emerging market stocks was the generalisation that they were more highly correlated to their local stock market than their global sector allocation.
While this tendency has grown more muted over the last couple of decades, the dispersion across emerging markets in the immediate aftermath of the US election was quite striking. Russian stocks climbed 20% between 8 November and mid-February, while Polish and Egyptian equities were up about 12% over the same period. Mexican stocks fell 12%.
Are emerging markets riskier than developed? Economist and entrepreneur Jerome Booth always likes to proclaim that the difference between the two is that, in emerging markets, risk is acknowledged and discounted, while developed markets suffer from a misperception of risk.
From a developed market investor point of view however, as Subramaniam points out, single-country emerging market portfolios can remain riskier than their developed market counterparts by one important measure: currency risk. MSCI finds that in many countries, over 40% of market volatility arises solely from currency effects.
Yet what Subramaniam does not point out in his article is that developed markets also see tremendous volatility from similar sources. The Brexit vote caused sterling to fall almost 20% against the dollar and has every chance of falling much further. The long-term survival of the euro is also at risk with political uncertainties sweeping across Europe.
While currency risk is inherent in any emerging market transaction, it is also present in a developed market transaction outside the home market. The management of this risk is primarily through diversification across the universe of emerging markets. But as the divergence between developed and emerging markets grows stronger, the rationale for having separate passive global emerging market mandates may become weaker.
Subramaniam argues that the divergence in results across emerging markets suggests that, as emerging markets mature and both country and currency effects widen, institutional investors can implement more active mandates to take advantage of the differences. Provided, that is, they are willing to accept the risks.
Perhaps the greater problem investors have faced in emerging markets, however, has been the volatility associated with large scale flows into and out of global emerging market exchange-traded funds, which have pushed markets both up and down. For long-term institutional investors, perhaps such volatility should be discounted – and investment decisions made on assessments of fundamental valuations rather than fund flows. That would suggest treating major emerging markets such as China and India as separate investment destinations in their own right, much as Japan has been considered for the past three or four decades.
What is clearer is that passive global emerging market allocations based on a market cap weightings give institutional investors excess volatility associated with fund flows rather than fundamentals. Perhaps it is time for a more intelligent approach.