Over the past years, the MSCI emerging markets equity index has formed weighting biases and shortcomings, says David Dali, portfolio strategist at Matthews Asia, who recently published a piece on six sources of alpha within emerging markets.
Yet opportunities are available in emerging markets for investors to capitalize on, he says, highlighting the importance of getting the Asia component right.
“China’s a fantastic case where only last year there were literally 2,700 companies available in the China investable index or investable universe and today there are over 6,400 of those companies and the majority of those companies are small- and mid-cap Chinese stocks that are not covered by analysts,” says Dali.
Other sources of alpha include building a better value portfolio to address the benchmark’s bias toward low quality, acknowledging the benchmark has a technology bias and understanding the benchmark is underweight small caps, he wrote in the piece.
“To give you a sense, there are, in my mind, about 14,000 companies in the emerging market universe that are investable and 74 per cent are small cap. Yet less than five per cent of the emerging markets index is small cap,” says Dali.
With emerging markets slowing, investors can also look for exposure to smaller faster growing economies, he notes. “Emerging markets has been slowing. The drivers of growth in the last 15 years have certainly been fading. The big countries like Korea, Taiwan, Brazil, Russia, South Africa — they’re just not growing as fast as they used to be.”
Other countries that could offer potential opportunities include Bangladesh, India, Pakistan, the Philippines and Vietnam, says Dali.
Investing in consumer-driven sectors is also a potential source of alpha, he adds.
“I would say that probably the largest diversifier for an institutional investor’s portfolio is the fact that the majority of the emerging markets benchmark is underweight what I think is the best investable theme for the next decade and that’s access to domestically oriented consumer businesses.
“And the reason is not just because we like the consumer theme as the region gets wealthier, especially in Asia, but because the consumer domestically oriented names are typically less volatile. They historically have had higher earnings growth and higher returns. They truly are a diversifier within an emerging markets portfolio.”