Emerging market (EM) equities form an important part of many European pension fund growth portfolios today. Investors are keen to capture excess returns on offer thanks to EMs’ risk premium over developed markets, as well as the diversification benefits they can bring to portfolios; these characteristics have been helpful for many of Europe’s DB and DC schemes.
Over the past 20 years, the markets classified as emerging have evolved significantly. In this article, we explore how index changes have brought new countries into the ‘emerging’ fold, we consider how investors are accessing emerging markets, and we give readers a sense of our current macro outlook on China.
Investments in China are subject to certain additional risks, particularly regarding the ability to deal in equity securities in China due to issues relating to liquidity and the repatriation of capital. As a result, the fund may choose to gain exposure to Chinese equities indirectly and may be unable to gain full exposure to Chinese equity markets.
1 BlackRock, Bloomberg as at August 2020.
2 MSCI, BlackRock as at December 2019.
Over the last 10 years, EM investing has evolved in numerous ways. From a sector perspective, in 2010, the MSCI EM index was weighted towards traditional industries such as materials and energy. Since then, the composition of the index has shifted, giving investors greater exposure to service-led industries like consumer discretionary and technology.1
The changing face of emerging market equities
Access to specific countries and markets has also improved for foreign investors. Historically, foreign investors had restricted access to several key emerging markets, including China and Saudi Arabia; 2019 proved to be a milestone for market access, with the inclusion of China A-shares (shares that trade in mainland China on domestic exchanges) and Saudi Arabian companies in the MSCI EM index. If we look at China specifically, the weight of MSCI China in MSCI EM has risen from 18% in August 2010 to 39% in August 20201; this increase was achieved through just 20% inclusion of China A-shares, with the MSCI EM and MSCI China indices expected to continue to evolve towards full A-shares inclusion.
As an investor, the changing landscape of EM investing highlights the importance of selectivity and understanding what’s ‘under the hood’ of a given index. The first MSCI index for emerging markets launched in 1988; since 2007, the range of indices has grown significantly.2 There are currently more than 5,000 different EM indices available, with offerings focused on diverse strategies and investor preferences – including ESG, factors, specific sectors, size, single countries and regions.2 Looking at performance in the year to date, MSCI EM Asia has outperformed MSCI Latin America by nearly 42% and MSCI EM by 9%, highlighting the potential for a more specific allocation to drive alpha.3 In addition, when breaking out the drivers of performance in EM, a recent MSCI report points to 60% of the factor contribution of performance coming from country allocations, with only 10 and 20% from industries and styles respectively.4
As with most asset classes, investors in the EM space may pursue active or index methods of implementation. From an index perspective, as the number of indices has increased, so too has the breadth of ETFs and index funds, giving investors possibilities that weren’t available a decade ago.
Similarly, investors may seek to invest strategically or tactically. Among European pension funds, we have seen a trend towards using broad EM exposures on a strategic basis. However, in line with increased selectivity, we have also noticed that some funds are becoming much more granular with their asset allocation, tilting towards factors, sustainability and single-country exposures on a tactical and strategic basis.
3 As at August 2020.
4 MSCI as at May 2020.
5 Bloomberg, as at 2 September 2020.
6 World Bank, April 2020.
7 BlackRock Investment Institute, with data from IMF, Refinitiv, June 2020.
Recent weakness of the US dollar and interest rate changes may be supportive of EM and could offer an attractive entry point for European pension funds. Global stimulus may feed through into better liquidity conditions, further helping EM economies, while the influx of liquidity from central banks and governments should also put an effective cap on the dollar.
A closer look at China
Against this backdrop, over the past few months we have seen increased interest on the part of European pension funds in EM Asia and particularly in China. China is seen as both a strategic allocation to capture the long-term growth story and a tactical trade, given China’s success in managing further Covid-19 outbreaks relative to developed countries, and its position further along in the virus recovery cycle. Indeed, through the recent crisis, China has proven its resilience as one of the best performing equity markets in 2020.5
European pension funds are increasingly using ETFs to access Chinese equity and bond markets to capture the strategic investment case for China. Nevertheless, China remains broadly under owned by investors globally, given the size of the country’s contribution to global GDP and growth. To put this into perspective, China hosts the second largest economy and the second largest bond and equity markets, yet foreign ownership of these markets is under 5%.6 As well as index inclusion, access to Chinese markets has improved in other ways, with ETFs offering low cost, transparent and rules-based benchmark exposure to Chinese equities and bonds.
Emerging markets, by definition, are not static – and as they ‘emerge’, they change and evolve. Over the last 30 years, we have seen a pace of change in emerging markets unmatched in developed markets. Asia ex-Japan today accounts for nearly 40% of global GDP, having made up closer to 15% in 1990; even more markedly, it now accounts for a greater proportion of global GDP than North America, Europe and Japan combined.7 This may be an ideal time for European pension funds to revisit their emerging market equity exposure. The changes across EM present wide-ranging opportunities, with China foremost among them.
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Emerging market equities: a changing landscape worth revisiting