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07 Nov 2019

Why and how investors allocate to emerging markets

Zoltan

In case you missed our recent webinar on ‘Building better EM portfolios’, we’ve recapped some key points made by Jean-Maurice Ladure, Head of Equity Solutions Research EMEA at MSCI. He draws attention to the importance of country choice in the context of EM investing, and highlights China in particular as a country that may be too big to ignore.


When we launched the MSCI Emerging Markets Index in 1988, the segment of the world it represented was quite modest: only 10 countries and around 1% of global market capitalisation.

Yet fast forward 30 years to today, and that 1% has multiplied in size twelve times, bringing EM to 12% of global market cap, with the index now reflecting 26 countries, and over 1,100 stocks.

And yet, even this much enlarged 12% figure represents only EM’s share of the free float stock market, the unrestricted universe preferred by institutional investors. If we change our lens to look at the full global market, by lifting some restrictions and accounting for state-owned companies, that 12% rises further to 22%. If we then turn to companies’ economic exposure – how much revenue they derive from EM versus DM – the figure shifts up by another 10% to 32%. Viewed this way, EM starts to be a very sizeable proportion of global market. Finally, our GDP-weighted indices have the figure higher still, at 40%.

As you can see, there are several ways to think about EM. Ultimately, it’s up to the investor to decide the significance of emerging markets in their portfolio

Evaluating opportunities in Emerging Markets

Why do investors consider EM? One reason could be the risk premium attached to the equity markets of EM countries. Since the MSCI Emerging Markets Index’s inception in 1988, the world’s developed markets have returned an average of 7.8% per year. Emerging markets have returned 10.3% per year over the same period, an extra 250 basis points of annual performance – albeit with periods of underperformance and volatility.

EM also has a low correlation to developed markets (DM), which can provide diversification benefits. And EM companies tend to be less covered by analysts than DM ones, which means one might expect more opportunities for alpha generation than DM stocks.

Those are some reasons why EM stock markets may present an investment opportunity. The natural question for an investor to ask is: how do you allocate to them?

Approaches to Emerging Markets

Investors have several options for approaching EM. Typical approaches include:  

1. Integrated EM investing

The investor has no strong view on EM but wants to capture the full equity risk premium globally.

2. Dedicated EM investing

The investor has a strategic view in terms of over/underweight to the broad emerging markets.

3. High conviction

The investor has high conviction on certain EM countries and want to take an active approach, or a specific theme in mind.

MSCI offers a wide range of indices to support investors seeking to approach EM in different ways, including:

  • MSCI ACWI Index which integrates DM and EM in a transparent way.
  • MSCI World Index and MSCI Emerging Market Index allowing you to dial up or down EM and DM exposure to reflect strategic views.
  • Single country indices such as MSCI China Index and MSCI India Index.

How broad EM performance hides significant country dispersion

There is a long-established risk/return trade-off between EM and DM. Historically, an EM investor benefited from higher long-term performance, at a cost of taking on more risk. However, at a broad level, in the last five years risk/return differences between EM and DM have declined.

Yet underneath this, there has been significant dispersion between constituent countries, especially in the emerging markets. Looking at 3-year annualised returns, a DM investor who avoided Germany (+5.2%) and chose the USA (+13.4%), would have seen a nice uptick in performance. Yet the spread on EM countries, where country is by far the greatest determinant of returns, is 3x wider. For example, an EM investor who chose Russian stocks over the same period would have gained 20%, while one investing in Mexico lost around -3%.

The message there is clear: country choice matters – a lot – for investors in the emerging markets. 

China – too big to ignore?

China’s stock market has drawn attention from global investors, especially as China A shares have been added to leading equity indices. We have been adding large-cap China A-Shares to our MSCI Emerging Markets Index since 2018, starting with a 5% inclusion over a two-step process, then another 5% added during the May 2019 rebalance, and another 5% in August 2019.  The final step in this inclusion will be later in November 2019 when we will add another 5% of China A large-cap stocks for a total of 20%, as well as 20% of China A mid-cap stocks. Even investors without a view on China might want to keep up to date with this growing emerging market.  

This article is for informative purposes only and should not be taken as investment advice. The opinions expressed by Jean-Maurice Ladure are his own, as at October 2019, and do not necessarily reflect the views of Lyxor International Asset Management or Societe Generale. Statements relating to past performance are not a reliable indicator of future results. Capital at risk. Please read our Risk Warning below.

MSCI disclaimer

The MSCI data contained herein is the property of MSCI Inc. and/or its affiliates (collectively, “MSCI”). MSCI and its information providers make no warranties with respect to any such data. The MSCI data contained herein is used under license and may not be further used, distributed or disseminated without the express written consent of MSCI. MSCI does not issue, sponsor, endorse, market, offer, review or otherwise express any opinion regarding any fund, ETF, derivative or other security.

Risk Warning

This document is for the exclusive use of investors acting on their own account and categorised either as “Eligible Counterparties” or “Professional Clients” within the meaning of Markets in Financial Instruments Directive 2014/65/EU. These products comply with the UCITS Directive (2009/65/EC). Société Générale and Lyxor International Asset Management (LIAM) recommend that investors read carefully the “investment risks” section of the product’s documentation (prospectus and KIID). The prospectus and KIID are available free of charge on www.lyxoretf.com, and upon request to client-services-etf@lyxor.com.

Except for the United-Kingdom, where this communication is issued in the UK by Lyxor Asset Management UK LLP, which is authorized and regulated by the Financial Conduct Authority in the UK under Registration Number 435658, this communication is issued by Lyxor International Asset Management (LIAM), a French management company authorized by the Autorité des marchés financiers and placed under the regulations of the UCITS (2014/91/EU) and AIFM (2011/61/EU) Directives. Société Générale is a French credit institution (bank) authorised by the Autorité de contrôle prudentiel et de résolution (the French Prudential Control Authority).

The products mentioned are the object of market-making contracts, the purpose of which is to ensure the liquidity of the products on the London Stock Exchange, assuming normal market conditions and normally functioning computer systems. Units of a specific UCITS ETF managed by an asset manager and purchased on the secondary market cannot usually be sold directly back to the asset manager itself. Investors must buy and sell units on a secondary market with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current net asset value when buying units and may receive less than the current net asset value when selling them. Updated composition of the product’s investment portfolio is available on www.lyxoretf.com. In addition, the indicative net asset value is published on the Reuters and Bloomberg pages of the product, and might also be mentioned on the websites of the stock exchanges where the product is listed.

Prior to investing in the product, investors should seek independent financial, tax, accounting and legal advice. It is each investor’s responsibility to ascertain that it is authorised to subscribe, or invest into this product. This document is of a commercial nature and not of a regulatory nature. This material is of a commercial nature and not a regulatory nature. This document does not constitute an offer, or an invitation to make an offer, from Société Générale, Lyxor Asset Management (together with its affiliates, Lyxor AM) or any of their respective subsidiaries to purchase or sell the product referred to herein.

Research disclaimer

Lyxor International Asset Management (“LIAM”) or its employees may have or maintain business relationships with companies covered in its research reports. As a result, investors should be aware that LIAM and its employees may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see appendix at the end of this report for the analyst(s) certification(s), important disclosures and disclaimers. Alternatively, visit our global research disclosure website www.lyxoretf.com/compliance.

Conflicts of interest 

This research contains the views, opinions and recommendations of Lyxor International Asset Management (“LIAM”) Cross Asset and ETF research analysts and/or strategists. To the extent that this research contains trade ideas based on macro views of economic market conditions or relative value, it may differ from the fundamental Cross Asset and ETF Research opinions and recommendations contained in Cross Asset and ETF Research sector or company research reports and from the views and opinions of other departments of LIAM and its affiliates. Lyxor Cross Asset and ETF research analysts and/or strategists routinely consult with LIAM sales and portfolio management personnel regarding market information including, but not limited to, pricing, spread levels and trading activity of ETFs tracking equity, fixed income and commodity indices. Trading desks may trade, or have traded, as principal on the basis of the research analyst(s) views and reports. Lyxor has mandatory research policies and procedures that are reasonably designed to (i) ensure that purported facts in research reports are based on reliable information and (ii) to prevent improper selective or tiered dissemination of research reports. In addition, research analysts receive compensation based, in part, on the quality and accuracy of their analysis, client feedback, competitive factors and LIAM’s total revenues including revenues from management fees and investment advisory fees and distribution fees.

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