Emerging markets as an investor classification has been haemorrhaging credibility for years. Bundling a vastly disparate jumble of countries into bond and stock indices and then branding them all as “emerging” was always a triumph of marketing over judgment.
But inherent contradictions are now getting too heavy to sustain. The issue is no longer simply that there is scant equivalence between the big, small, agrarian, industrialised, commodity exporting and importing countries that make up benchmark indices such as the MSCI Emerging Markets index and the JPMorgan Emerging Markets Bond index.
The more critical flaw is that the global themes that have lent the concept a degree of coherence are dissipating. New themes are starting to animate some countries and companies within the group, but the impact of these is likely to speed the disaggregation of the EM cohort rather than to reinforce it.
“From a portfolio perspective, we believe a one-size-fits-all classification of EMs no longer works and may in fact be misleading,” said Taimur Hyat, chief strategy officer at PGIM, which manages more than $1tn in assets worldwide.
“The (EM) indices are really inadequate at capturing the opportunity set because the opportunity has moved away and is likely to move even further in the future,” added Mr Hyat, who advocates an idiosyncratic strategy that seeks to identify value where it exists rather than simply allocating funds according to country weights in an index.
He is not the only one daring to diverge from the indices. “We have to be bold. If we promise our clients high-level thinking, we can’t just deliver returns that stay close to the index,” said one manager at a large global fund, who declined to be identified. “We have to explain the opportunity to our clients and then take risks in order to outperform.”
If such thinking spreads, the impact on emerging market investing could be fundamental. Some $1.6tn in funds track the MSCI Emerging Markets index, the benchmark for global equity investors in 24 economies as disparate as Qatar and Taiwan, China and the Czech Republic, and Pakistan and Peru.
In bond markets, a similarly mesmeric influence over capital flows is held by the JPMorgan Emerging Market Bond index series. Because fund managers use such benchmarks to advertise their performance, they try to reduce the risk of underperformance by buying the stocks or bonds that make up the indices they track.
This mechanistic approach also means that if, say, South Korea, has a 15.26 per cent weighting in the MSCI index, fund managers should mirror that allocation in their portfolios — regardless of how concerned they may be over the nuclear sabre-rattling of Kim Jong Un, the North Korean dictator.
“The top down country weights that you are locked into with the EM indices is not how you should think about the EM opportunity,” said Mr Hyat.
The time has come, several fund managers said, for a more imaginative approach. In any case, the big economic, societal and political changes sweeping the developing world bear little resemblance to the trends that prevailed in the early 1980s when the EM concept was born.
Climate change and the ascendance of “environmental, social and governance” (ESG) investment standards is one theme so big that it could single-handedly break the asset allocation mould. For example, the MSCI EM ESG Leaders index has outstripped the benchmark that it is formed from — the MSCI EM index — every year since the 2008/09 financial crisis.
If such a dependable outperformance can be secured by screening out companies that do not comply with ESG standards, then why should fund managers maintain unquestioning loyalties to their traditional benchmarks?
“That is a very fair question,” says Isabelle Mateos y Lago, Global Macro Investment Strategist at BlackRock. “Maybe we should ask the creators of these indices and adopt ESG indices only.”
Other themes reshaping emerging markets are also very different from those that once supplied coherence to the EM classification. In place of the globalisation of trade that bequeathed years of export-led growth to EMs, a new era of slowing aggregate demand has dawned as developed countries suffer sluggish productivity gains impacted by ageing populations.
But within emerging markets themselves, trade is still growing as an ascendant middle class of more than 1.5bn people who spend more than $15tn annually reshape the global consumer map. Several developing countries, meanwhile, are outstripping developed counterparts in the embrace of digital technologies, fintech and renewable energy.
Capital markets in parts of the developing world are also deepening at an impressive rate as emerging companies that are far below the radar of benchmark indices issue stocks and bonds to finance their growth strategies.