The question of whether and how to invest in emerging market equities is one that is often asked by investors. There seems to be broad support for the thesis that emerging economies offer access to superior long-term, albeit volatile, growth. The question remains how investors can best access that growth. While many investors have already made the decision to invest, either through a discrete allocation or through existing global or international equity managers, there are many who have yet to jump on the bandwagon.
Although emerging market countries represent almost 50% of world gross domestic product (GDP), their share of the world equity market indices is only about 11% and investor portfolios tend to hold substantially less than this (average allocations are thought to be around 5%).
We often speak about the emerging markets as a single entity. In reality, emerging market countries are just that–a large number of countries spread across five continents with different political and regulatory regimes, demographic profiles and cultural preferences. There are literally thousands of companies that are publicly listed and traded in these countries, but for reasons of liquidity (free float and other local restrictions), only 800 securities are represented in the MSCI Emerging Markets Index.
There are 21 countries represented in these 800 securities; however, four countries account for 56% of the market capitalization. Furthermore, a few large companies in the energy, financial and technology sectors dominate the index. In other words, this is not a broad, diverse Index. Interestingly, the Canadian equity market is dominated by energy, materials and financial services, so there appears to be a sector concentration and overlap issue here for most Canadian investors.
The emerging countries, unlike developed countries, tend to have a large proportion of their companies owned in part by the state (state-owned enterprises or SOE). In fact, many of the large energy, financial and telecommunication companies in the Index are owned by SOEs (in particular, China and Brazil), and they account for almost 25% of the index. Contrast this with developed markets, where less than 2% of developed market companies are controlled by SOEs.
The question of whether to implement through a standalone allocation or through global/international equity managers is a fundamental philosophical decision. However, this article will confine itself to the former. Implementation options for emerging market equities are similar to those for developed market equities–passive, active, and smart beta.
Passive products have been developed and are reasonably cheap with pretty close tracking to the index. While exchange-traded funds (ETFs) have also been developed to track the index, they are more expensive than physical fund options due to embedded costs and have displayed fairly high tracking errors over time.
Active management in emerging markets should, in theory, be attractive. There is less analyst coverage of these companies and active managers are potentially better able to assess the quality of company governance and management actions. Active management often requires large teams because of the diverse markets, cultures and languages. This in itself presents a challenge as communication and culture require greater coordination. Fees have traditionally been high, given the labour-intensive nature of research and security selection in emerging markets. However, if it keeps the investor out of companies that are not friendly to minority shareholders, it may easily pay for itself.
Smart beta strategies and products have been a recent addition to the implementation toolbox. The main driver of smart beta is to capture a particular risk premium for a low cost. Smart beta approaches often include value weighted, low volatility and diversification based strategies. Given the concentrated nature of the Index, a non-capitalization weighted approach might make sense. Fees for smart beta strategies are higher than passive but almost one-third of active fees.
For those who have not already invested in emerging market equities but wish to do so, there is a lot to consider. It’s worth spending the time to determine the implementation approach that makes the most sense given the organization and its objectives, and your governance capabilities.