Disparate Emerging Market Returns

Mon 08 Jul 2019

• The chart below shows the range of returns across top nine countries in the MSCI Emerging Markets index by market capitalisation. Combined they make up 88.6% of the index
  as of the end of March. The vast majority of emerging market equity funds use this as their benchmark. The largest constituent in the EM index is China, at 33%. In contrast global equity indices tend to have a weighting of around 60% to the largest constituent, the US.

• Some equity funds purposefully maintain geographic weightings in line with index weightings to avoid the issue that, especially in times of crisis for a particular country, virtually all equities are likely to sell-off regardless of underlying firm fundamentals.
• However most funds do not do this, with differing methods for allocating assets between geographies. Some funds are 100% ‘bottom-up’, investing solely based on their view of relative fundamental strength of companies. Others may be 100% ‘top-down’, investing solely based on their view of the outlook for each country’s equity market. Most funds are somewhere in between.
• For global equity funds which don’t match country index weightings the biggest asset allocation decision is whether to be under or over-weight US equities. Although a difficult decision it is largely binary, and not something a fund manager will need to spend a significant amount of time considering. Further, as the index weighting is dominated by developed nations, there is less concern about being overweight in a country where there could be a crisis, so that dispersion of returns is generally much more muted.
• By contrast for EM equity funds which don’t match country index weightings have the issue that there is a much higher likelihood of a crisis for a significant index member. Also, while China is easily the largest country by market capitalisation, it does not dominate returns in the way the US does in global indices, increasing the amount of time needed to decide on regional allocation. And unlike the US, which is widely regarded as one of the most stable economies in the world with a well developed rule of law, there are many concerns about the stability of the Chinese economy as well as corporate governance. As such many EM funds are nervous about allocating any assets to the region.
• From our analysis we believe it is extremely difficult to determine which countries within EM are likely to over and under-perform in both the short and long-run. As such it becomes a toss-up whether geographic allocation decisions add or detract value. For now we are investing our EM exposure in passive funds in order to remove the risk of underperformance from geographic return dispersion.