Five Reasons to Buy Emerging Markets Equities

Emerging Markets (EM) have faced a challenging environment over the past five years, due to a series of global shocks that have triggered elevated market volatility and led the MSCI EM equity benchmark to experience its most protracted drawdown in history. In this environment, global asset allocators effectively deprioritised EM, risking suboptimal allocations. There are five reasons why asset owners should consider re-engaging with EM equity.

1 | EM is too big to ignore

Global allocations are often framed by third party-defined weightings such as the MSCI All Country World Index.1 This market cap-based index requires investors to have a 12% EM exposure for a neutral position. Pension fund surveys suggests the sector holds a material underweight, highlighting investors’ light positioning. However, this misses a more significant point. Market cap-based approaches grossly underestimate EM’s importance. EM represents 60% of global gross domestic product GDP (based on purchasing power parity), underpinned by 88% of the world’s population. More relevantly for equity investors, as Figure 1 shows, 34% of global revenues derived from EM, while North America is massively overrepresented in relation to the share of global revenues.

2 | EM specialisation and diversification matter

EM’s earlier stage of development and secular growth drivers – such as better demographics and technological leapfrogging – mean they have a higher return potential. However, EM’s evolving macroeconomics, immature institutions and more complicated governance structures also mean they can be volatile and are traded as a ‘risky assets’. These characteristics create significant market inefficiencies and ample opportunities for active managers, and as a consequence, 75% of EM equity managers outperform their benchmark over time, compared to 25% for US equity managers.

Some investors choose to access EM equity markets indirectly, via global equity managers who consider EM stocks as part of their global portfolio, or by investing in developed markets (DM) multinationals that generate some of their revenue from EM. Both approaches are suboptimal, in our view. The first tends to result in an under-allocation to EM, as global managers typically focus their limited resources on DM, their largest ‘benchmark risk’. According to data provider eVestment, global equity managers held on average only 6% in EM as at 31 December 2022. With the second method, the investable universe is materially reduced with negative implications for portfolio diversification and alpha generation. The MSCI World with EM Exposure index, comprising DM stocks with the most revenue generated from EM, has 80% fewer companies than MSCI EM. Furthermore, both approaches are compromised by overinflated stock prices. The price-to-earnings ratio for the MSCI World with EM Exposure index is 80% higher than for the MSCI EM index! Lastly, investing directly in EM pays off: Ashmore EM Equity stands at the top-decile of its peer group over five years in Morningstar’s universe to 28 February 2023. See: Ashmore Emerging Markets Equity Fund 5 year anniversary!