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emerging markets
C HANGING DYNAMICS IN EMERGING MARKETS
Considering new approaches for a changing investment landscape
EXECUTIVE SUMMARY
EMERGING MARKETS HAVE “GROWN UP”
At its inception in 1988, the MSCI Emerging Markets Index represented just 1% of the global
market capitalization1. Just eight countries and 290 securities were included in the index, and
there was little transparency for investors, with virtually no analyst coverage. There were no
CHART 1: GLOBAL EQUITY OPPORTUNITY SET
Emerging markets
now represent 13%
of global market cap.
35,000
30,000
25,000
20,000
15,000
Emerging markets
represented 1% of
global market cap.
10,000
5,000
0
8
19
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90
19
91
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92
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93
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94
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95
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10
20
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12
Ben Goetsch
Investment Strategist
Associate, Index
Management
19
8
Greg Behar
Senior Investment
Strategist, Index
Management
Emerging market economies, once on the fringe of the investment spectrum, have become
a dominant force behind global growth and a staple of equity portfolios. As a result, the correlations between emerging and developed markets have increased, and traditional emerging market
investments have become a less meaningful source of portfolio diversification. In addition, high
security return correlation and low country return dispersion also have limited opportunities
for outperformance through traditional strategies.
However, this does not mean that emerging markets can no longer play a valuable role in global
portfolio allocations. Instead, it means investors would be wise to take a fresh look at their emerging
market exposure and how they can achieve it. Expanding into small cap emerging markets equities
and frontier markets can provide many of the opportunities early investors in traditional emerging
markets saw. Though emerging markets have become more efficient, costs remain relatively high
and liquidity relatively low, making index strategies an attractive means of gaining quick and
efficient exposure. Investors may benefit from considering a core/satellite approach to their
portfolio construction: gaining their core exposure to the asset class through a market cap weighted
index approach, while targeting potential market inefficiencies and specific investment goals with
active or alternatively weighted satellite strategies.
Developed World
Emerging Markets
Source: MSCI, Bloomberg, Northern Trust.
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The evolution of these
markets has dramatically
changed the investment
landscape, and investors
should consider what
this means for their
emerging markets portfolio
implementation.
passive managers in the space, and active managers were able to take advantage of mispricing
resulting from illiquidity and incomplete information.
Since then, emerging markets have grown up. A series of substantial economic reforms in
the 1990s and the adoption by many countries of U.S. generally accepted accounting principles
(GAAP) decreased many of the operational and regulatory risks that previously had plagued
emerging market investments, and investors began flocking to emerging markets.
The MSCI Emerging Markets Index now represents 22 markets and makes up 13% of the
global market capitalization. On average, 22 analysts now cover each of the 820 constituents in
the index, and funds have been flowing increasingly into passive products, with $134 billion
currently managed by emerging markets exchange traded funds (ETFs).
The evolution of these markets has dramatically changed the investment landscape, and
investors should consider what this means for their emerging markets portfolio implementation.
The continued reduction of barriers to foreign investment in these markets will change the effectiveness of certain strategies, especially given the increased use of index products. Additionally, as
developing economies become more mature, the diversification, risk and growth characteristics
of their equity markets will change how they fit into global portfolios. Emerging markets continue to serve a valuable role in a global equity portfolio, but investors would be wise to reconsider how they think about the asset class, weighing the benefits of including passive vehicles and
broadening their allocation to include small cap and frontier markets as well.
EFFICIENCY BRINGS HIGHER CORRELATIONS
One consequence of the maturation of emerging markets has been an increase in security correlations within the segment. Improved information flow and increased competition among
managers have diminished stock-picking advantages. Emerging markets stocks are now moving
more in synch. This has been compounded by the increased use of passive management. More
than 25% of all emerging markets assets are now invested through index products, up from just
10% five years ago (Chart 2).
Chart 2: Emerging Markets Index Assets on the Rise
Emerging markets equity index assets relative to total emerging markets assets.
30%
25%
20%
15%
10%
5%
0%
2007
2008
2009
2010
2011
2012
Source: EPFR, Northern Trust. Data to March 2012.
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Chart 3 shows the
historical median
Pairwise correlations have been trending upwards in both developed and emerging markets.
security pairwise cor70%
relations in developed
and emerging markets.
60%
While both market
50%
segments show periods
of both high and low
40%
correlations, emerging
30%
market correlations
have been trending
20%
upward over time. We
see the most dramatic
10%
rise in correlations
0%
between 2007 and 2009,
coinciding with a substantial increase in the
DM Correlation
EM Correlation
DM Rolling
EM Rolling
use of index products
Source: MSCI, Bloomberg, Northern Trust.
in emerging markets.
Correlations are just
one part of the story, and they do not necessarily indicate less opportunity. However, the difference
between emerging market country returns also has been falling over the same period (Chart 4). Country differentiation historically has been a main driver of relative performance in emerging markets, as
managers have attempted to identify markets with relatively more attractive economic fundamentals.
However, country dispersion within emerging markets has come down from levels as high
as 20% to just below 5%, meaning that strategies attempting to outperform by over- and underweighting countries may not pay off as well in the future.
The high security
return correlation and
Chart 4: Country-Level Dispersion
low country return
The country factor has become less significant as a driver of emerging-market returns.
dispersion also have
25%
limited opportunities
for outperformance
20%
through traditional
strategies. This has
15%
created a difficult
environment for fundamental active emerging
10%
markets managers.
The median active
5%
manager has outperformed the MSCI
0%
Emerging Markets
Index by just 1.12%
MSCI World
MSCI EM
DM – Trend
EM – Trend
annually over the
past five years, barely
09
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9
00
9
19
9
20
19
97
6
8
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9
19
9
19
97
19
9
5
Chart 3: Median Pairwise Correlations
Source: MSCI, Bloomberg, Northern Trust.
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Complementing market-cap
weighted index exposure
with smaller, targeted
non-market-cap weighted
strategies may have
more potential for
outperformance while
avoiding excessive
uncompensated active risk.
recovering management fees, which can be well over 1.00% for emerging markets active managers.
This outperformance also does not take survivorship bias into account, because funds that have been
closed in the interim period are not included in the analysis.
There will be opportunities in the future to generate outperformance as correlations and
dispersions oscillate over time, but managers will continue to face long-term headwinds. Investors
should consider whether they will be adequately compensated for the active risk these strategies
are taking. The median 10-year tracking error of emerging markets active managers is above
4%, resulting in a gross information ratio of just 0.242. When taking fees into account, the active
risk may have gone totally uncompensated. Though some managers have
Table 1: The median active manager has had
been able to perform well, the large
difficulty outperforming net of fees
fund flows they attract limit their
Active Emerging Markets Equity Relative Returns (Gross of Fees)
ability to target the best opportunities,
resulting in actively managed portfo3 Yrs.
5 Yrs.
7 Yrs.
10 Yrs.
lios that are heavily concentrated in
25th
4.27%
3.92%
2.74%
3.14%
the larger companies already found
Percentile
in the benchmark. Complementing
Median
1.82%
1.12%
1.30%
1.61%
market-cap weighted index exposure
95th
with smaller, targeted non-market–4.00%
–3.72%
–2.30%
–1.32%
Percentile
cap weighted strategies may have more
Active Emerging Markets Management Fees
potential for outperformance while
avoiding excessive uncompensated
Commingled
Mutual
SMA
Fund
Fund
active risk.
Finding fundamental active managMedian
0.90%
0.92%
1.25%
ers who deviate from the benchmark
Source: eVestment Alliance, Northern Trust. Data as of 12/31/2012.
and have the combination of capacity
and a long term track record has become increasingly difficult. While investors skilled in selecting
active managers may be able to identify potential outperformers, many investors are turning their
focus to market-cap weighted and alternatively weighted index products for implementation.
GLOBALIZATION NARROWS GAP BETWEEN EMERGING AND DEVELOPED MARKETS
As globalization has taken hold, international markets have become more highly integrated.
Many developed market companies, seeing better growth opportunities, have expanded into
emerging markets in the past decade. As of 2011, the MSCI World Index had 21% revenue
exposure to emerging markets, up from just 10% in 20023. Additionally, several large constituents
of the MSCI Emerging Markets Index have grown internationally, deriving most of their revenues
from outside of their country of domicile and a large portion from outside of the emerging market
economies. For example, Table 2 highlights four large constituents of the MSCI Emerging Markets
Index that generate a significant portion of their revenues from outside of their home country.
Table 2: Portion of Revenues Generated Outside Company’s Home Country
Taiwan
Semiconductor
Kia
Infosys
Samsung
Outside of Home
Country
88%
78%
98%
84%
Europe/America
70%
58%
87%
53%
Source: FactSet, Northern Trust. Data as of December 2011. Infosys data is as of March 2012. Due to different
reporting methods, "America" includes just the United States for Samsung and Taiwan Semiconductor. For Infosys
and Kia, "America" is North America.
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Chart 5: Sector Composition of MSCI Emerging Markets Index
Emerging markets have become more exposed to global sectors, such as information technology,
energy and financials.
100%
Emerging markets are now
tilted more toward sectors
that are heavily affected
by global factors, such as
information technology
and energy.
Health Care
90%
Utilities
80%
Industrials
70%
Telecommunication Services
60%
Consumer Discretionary
50%
Consumer Staples
40%
Materials
30%
Energy
20%
Information Technology
10%
Financials
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12
0%
Source: MSCI, FactSet, Northern Trust.
In addition, the development of these economies has resulted in a substantially different sector
concentration. For example, in 2011 information technology companies comprised 13.1% of the
market capitalization of the index, versus just 1.5% in 1994. Emerging markets are now tilted more
toward sectors that are heavily affected by global factors, such as information technology and energy.
On the other hand, sectors driven more by local factors, such as utilities and consumer discretionary,
have become less significant in emerging markets.
The result has been a gradual increase in the correlations of emerging and developed markets.
Emerging markets were less than 50% correlated with developed markets in the late 1990s, but
they are now approximately 90% correlated (Chart 6), eroding potential diversification benefits.
Chart 6: Rolling Five-Year Correlations to MSCI World Index
Emerging markets have become more highly correlated with developed markets over time.
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
2
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20
12
0%
19
9
Emerging markets were
less than 50% correlated
with developed markets in
the late 1990s, but they
are now approximately
90% correlated, eroding
potential diversification
benefits.
MSCI Emerging Markets
Source: MSCI, Northern Trust.
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To maintain diversification
and participate in the
next generation of growth
opportunities, investors
may want to expand their
portfolios deeper, to include
small cap emerging market
stocks, and broader,
into frontier markets, to
complete the global equity
opportunity set.
In the last few years, correlations across asset classes have increased dramatically, a trend that
has been related to the financial crisis of 2008. However, the correlation of emerging markets to
developed markets has been a long, gradual process connected to globalization and international
expansion of both developed and emerging market companies.
COMPLETING THE GLOBAL EQUITY OPPORTUNITY SET
Emerging markets still offer diversification, though not at the same level as in the past, and emerging
market companies have become important components of any equity portfolio. However, to maintain
diversification and participate in the next generation of growth opportunities, investors may want to
expand their portfolios deeper, to include small cap emerging market stocks, and broader, into frontier
markets, to complete the global equity opportunity set. By doing so, investors can reduce total
portfolio risk while gaining exposure to significant growth potential.
Chart 7: Emerging Market Capitalization Breakdown
The complete emerging markets opportunity set includes emerging large-, mid- and small-cap,
and frontier markets.
Emerging Markets Characteristics
(As of December 31, 2012)
Developed
International
Markets
75%
Emerging
Markets
25%
% of
Opportunity
# of
Countries
# of
Securities
Emerging Markets
Large/Mid
84.5
21
821
Emerging Markets
Small
10.9
21
1,795
4.6
36
593
Frontier Markets
Source: MSCI, S&P, Northern Trust. Data as of December 31, 2012.
Emerging markets large-, mid- and small-cap are MSCI indices. Developed
international markets is the MSCI World ex USA. Frontier markets is the
S&P Frontier Markets BMI.
Emerging Markets Small Cap Deepens Portfolio
In the past, investors were hesitant to expand their emerging markets portfolios to include smaller,
less liquid names. However, MSCI’s introduction of the Global Investable Market Index series in
2006 made investors more aware of the investability and potential benefits of global small cap
stocks. As emerging markets have matured, funds have flowed into the small cap segment, providing
additional investable growth opportunities. Small cap equities tend to have more volatile returns,
but this “size risk” historically has been compensated by higher returns in the long run. This has
been especially true in international markets. The diversification and growth benefits of the
segment make a compelling case for an allocation to emerging small cap.
Emerging market small cap equities present substantial opportunities for increased diversification. The MSCI Emerging Markets Small Cap Index includes nearly 2,000 companies making
up 11% of the emerging markets opportunity set4. In addition to reducing individual security
risk, the emerging markets small cap equities provide increased diversification relative to large
and mid cap emerging market equities. For example, Brazil and China, which together represent
more than 30% of the MSCI Emerging Markets Index, are just 22% of the small cap benchmark
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(Chart 8). This helps reduce the risk of concentration in the larger and more developed countries
that may now experience slower growth than in the past.
Chart 8: Country Breakdown of MSCI Emerging Markets Indices
Emerging markets small cap offers differentiated country exposure from the standard benchmark.
Morocco
Hungary
Czech Republic
Egypt
Peru
Philippines
Columbia
Poland
Chile
Turkey
Thailand
Indonesia
Malaysia
Mexico
Russia
India
South Africa
Taiwan
Brazil
South Korea
China
0
2%
4%
6%
8%
MSCI Emerging Markets Small Cap
10%
12%
14%
16%
18%
20%
MSCI Emerging Markets
Source: MSCI, Northern Trust. Data as of 12/31/2012.
Emerging market small cap
equities present substantial
opportunities for increased
diversification.
The emerging markets small cap segment is also potentially less exposed to global factors. Small
cap stocks tend to be more local in nature than those found in the standard benchmark, which
often are large multinational companies. Additionally, the benchmark tilts more toward local
sectors than its standard counterpart (Chart 9 on page 8). The relatively high weights of locally
exposed sectors like healthcare and industrials, as well as a significant underweight to energy
companies, can help reduce a portfolio’s correlation with developed markets. Additionally, the
added exposure to the consumer discretionary sector positions small cap stocks to benefit from
the growing middle class and steady transition to consumer economies in emerging markets.
Emerging market small cap equities also are poised for substantial earnings growth in the
coming years. Three- to five-year projected earnings growth for the MSCI Emerging Markets
Small Cap Index is 18.4%, versus just 11.9% for the standard MSCI Emerging Markets Index5.
Even with this potential growth, emerging small cap stocks have been trading at a forward
price-to-earnings ratio of 10.62x6, similar to the standard index, which trades at 10.75x.
While the difference in valuations can be partly attributed to the segment’s higher risk, the expected
earnings growth makes an allocation compelling. Emerging small cap also maintains a yield of
2.71% versus 3.00% for the standard index. Through an allocation to emerging market small
cap, investors can increase their emerging markets diversification without sacrificing exposure
to potential earnings growth or income.
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Chart 9: Emerging Markets Sector Breakdown
Emerging market small cap is less exposed to global sectors like energy and financials
Health Care
Utilities
Industrials
Many investors consider
frontier markets to be the
next generation of emerging
markets.
Telecommunication
Services
Consumer
Discretionary
Consumer Staples
Materials
Energy
Information
Technology
Financials
0%
5%
10%
15%
MSCI Emerging Markets Small Cap
20%
25%
30%
MSCI Emerging Markets
Source: MSCI, Northern Trust. Data as of 12/31/2012.
Frontier Markets Broaden Exposure
Addressing Environmental,
social and governance Concerns
in Emerging Market Investments
As responsible investing research coverage
in emerging markets has expanded, it is now
possible to implement a strategy that incorporates environmental, social and governance
(ESG) factors – including addressing potential
concerns about the corporate governance of
emerging markets companies. A large percentage of listed firms in emerging markets still have
high implicit and explicit government ownership
levels, prompting concerns about government
influence on these firms’ performances. Similarly,
a company’s board composition or social issues,
such as labor rights in China, create potential
risk. Applying screens to limit exposure to undesired companies, while maintaining a broad and
diversified approach in emerging markets, can
help mitigate these risks.
Many investors consider frontier markets to be the next generation of
emerging markets. Like emerging markets in 1988, frontier markets
currently represent approximately 1% of the global equity universe.
They tend to be developing countries with high rates of economic
growth and small, relatively illiquid stock markets. Typically, these
markets have less advanced operational infrastructures than more
established markets, which is the main reason for their exclusion from
emerging market benchmarks. However, the risks are surmountable for
investors who understand them and are willing to conduct the additional due diligence required to invest in these markets.
Frontier markets offer significant diversification benefits within a
global equity portfolio. Many of the constituents do not have significant exposure to global factors, resulting in lower correlation and
attractive risk/return characteristics. Frontier market returns have historically been less volatile than emerging markets, with growth that has
outpaced developed markets. The result has been a 10-year Sharpe ratio
of 0.50 for frontier markets versus 0.36 for developed markets. Frontier
markets have also been just 74% correlated with developed markets over
the past 10 years, while emerging markets were 89% correlated.7
These markets also have the potential to grow substantially in the
coming years, with average real GDP growth in frontier markets expected
to outpace developed markets by 2% annually over the next five years.
Additionally, there is significant room for “equitization” in the frontier
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Chart 10: Frontier Markets Real GDP Growth
Frontier markets have significantly higher expected gross domestic product (GDP)
growth than developed markets.
Five Year Actual and Projected
Real GDP Growth
5%
4%
3%
2%
1%
0%
Avg. 2006 – 2011
Developed Markets
Avg. 2012 – 2017 (est.)
Frontier Markets
Source: International Monetary Fund, Northern Trust. Data as of October 2012.
economies because their less mature capital markets are small relative to GDP. As these economies are gradually liberalized and opened to increased foreign investment, their equity markets
could see exceptionally strong returns.
Frontier markets could also benefit from a “graduation effect,” which has the potential to
enhance returns for early investors. Several more highly developed frontier countries could be
reclassified as emerging markets relatively soon. For example, countries like the United Arab
Emirates, which is already classified as an emerging market by FTSE, and Qatar are currently being
considered for graduation to emerging by MSCI. By owning equities in these markets prior to their
graduation, investors could benefit from the potential wave of buying that will occur in emerging
market index funds when the new markets are added to the benchmark. This pattern could repeat
itself as more countries reduce regulatory and operational risks and become more investable.
Combining index and active strategies IN EMERGING MARKETS
Within emerging markets, investors should focus on gaining exposure to the high level of
potential growth and adding portfolio diversification in the most efficient manner. Using market
cap weighted index products can allow investors to quickly gain this exposure within a transparent,
rules-based framework while avoiding the active management fees. At the same time, there may
also be opportunities to add alpha, increase diversification and target goals through satellite allocations within emerging markets. However, investors should be wary of capacity constraints;
active managers may have difficulty finding opportunities to effectively invest large amounts
without incurring significant impact costs.
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Investors can use non-market cap weighted strategies to tilt toward certain compensated risk
factors, such as size, value and low volatility. Such strategies can effectively complement broadbased market cap weighted core exposure. Some situations may also lend themselves well to
fundamental active managers, particularly if the managers are local and have some information
advantages. Smaller managers with capacity and that differentiate significantly from the benchmark could be the best positioned to perform well going forward. However, investors with the
ability and resources to identify these managers will have a better probability of generating excess
returns through active strategies. When selecting any satellite strategy, investors should carefully
consider whether the strategy aligns with their investment goals.
Chart 11: Emerging and Frontier Markets can now be used as core exposures
with alternative strategies in the satellite.
Active Stock Selection
Alternative Index
Core Exposure
Investors can use nonmarket cap weighted
strategies to tilt toward
certain compensated risk
factors, such as size, value
and low volatility.
Emerging Market Index
(large, mid, small)
+
Frontier Markets
Engineered Beta
Country Selection
CHANGES IN EMERGING MARKETS REQUIRE A NEW APPROACH
As traditional emerging markets have matured, the optimal implementation of an emerging
markets equity allocation has changed. To continue to reap the diversification benefits and the
potential for enhanced returns emerging market investments traditionally have brought to a
portfolio, investors will need to rethink their approach. Today, investors may want to target
potential growth opportunities by expanding their emerging markets allocations to include
small cap equities, which offer diversification benefits with differentiated country and sector
exposures and have historically outperformed the emerging markets benchmark, and frontier
markets, which offer the potential growth of rapidly growing economies. Frontier markets
have also historically had a relatively low correlation to developed markets, adding to overall
portfolio diversification.
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Learn more
If you would like to learn more about how the changes in emerging markets may be affecting
your portfolio, or whether broadening your allocations to include small cap or frontier market
equities might help you meet your goals, please contact the Global Index Strategy Team at
global_index_strategy@ntrs.com.
Acknowledgements
The authors would like to thank the following Northern Trust partners for their contributions,
analysis, research, and support in the production of this paper: Michael Kovacs, Stefanie Hest,
Alain Cubeles, Tom Wackerlin and Bethany Morris.
End notes
1
As measured by the MSCI All Country World Index
2
Source: eVestment Alliance.
3
Source: MSCI: “Economic Exposure to Emerging Markets”
4
MSCI Emerging Markets, MSCI Emerging Markets Small Cap, S&P Frontier Markets BMI
5
Source: FactSet, Northern Trust. Data as of 9/28/2012.
6
As of 9/28/2012; source: MSCI.
7
Source: S&P Dow Jones, MSCI, Northern Trust. Frontier is S&P Frontier BMI, emerging is MSCI
Emerging Markets, and developed is MSCI World. Data as of 12/31/2012.
northerntrust.com | Emerging Markets | 11 of 12
.
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