Emerging Markets 3.0The Evolution of Emerging Markets Equities in Investors’ Portfolio

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In December 1987, MSCI introduced the MSCI Emerging Markets Index, essentially ushering in the genesis of the emerging markets as a distinct asset class. At its inception, the index covered ten countries.1 Since that time, emerging markets have solidified their position as a piece of the allocation within investors’ portfolios. The index covers 26 countries, frontier markets have appeared as an asset class, and the choices of options for emerging markets investment have grown.

At the inception of emerging markets investing, participants struggled to define the market segment. Broadly speaking, the idea was to create an investment in “a set of promising stock markets, lifted from obscurity, thereby attracting the investment they needed to thrive.2”

The moniker “emerging markets” evolved as part of a marketing strategy. Investment managers liked the investment concept but disliked the original name given to the strategy – Third World Equity Fund. The term “emerging markets” was born to convey the idea of progress, uplift, and dynamism.

After more than 30 years, a uniform definition of emerging markets is still lacking.

In this article, we highlight the growth of emerging markets as a distinct asset class and how the options of gaining exposure to the space have evolved over time. We also make the argument for why the average investor needs to rethink their allocation to this rapidly changing asset class.

EM 1.0 – The Early Days – 1987-2002

Early on, most investors’ exposure to non-US markets was limited to developed countries. However, investors began to recognize the potential growth of emerging markets and the appeal of increasing their diversification to these less covered geographies.

For most investors, the initial foray into emerging markets was relatively limited given the number of publicly traded companies available at the time and the heavy concentration in commodities, financials, and energy. Typical allocations to the asset class were generally limited to around 2%-3% of the total portfolio3 as investors dipped their toes in the water.

Additionally, initial exposure to emerging markets was through broad-based indices, which treated all emerging market economies and financial markets as one heterogeneous block.

EM 2.0 – A More Meaningful Allocation to Emerging Markets – 2003-2018

With a toehold established and increasing familiarity, institutional investors became more comfortable with holding an allocation to emerging markets in their portfolios. As a result, they began to increase their exposure to the asset class to a weighting somewhere in the 10%-20% range, mirroring an MSCI All Countries World Index-like (ACWI) exposure.3

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During this time period, some investors became comfortable with holding an overweighting in emerging market equities.

However, exposure to emerging markets was still achieved through broad-based portfolios which, again, treated the emerging markets as one heterogeneous block.

One particularly troublesome characteristic of broad-based emerging markets indices is their inclusion of state-owned enterprises (SOEs). Their inclusion may weigh down investment returns as SOEs are often characterized by lower levels of operational efficiency, poor corporate governance, and corruption. Since making a profit may not be part of their mission, they may not be representative of the new entrepreneurial businesses that are transforming the economies of emerging markets countries.

Launched on 11/12/14, the Emerging Markets Internet & Ecommerce ETF (EMQQ) addresses this potential downfall by excluding SOEs from the portfolio. Thus, we feel that the fund is more reflective of the potential growth opportunities afforded by an investment in the emerging markets.

EM 3.0 – Broader and More Variegated Exposure – 2018 +

While allocations to the emerging markets did not increase meaningfully in this evolutionary period, the options for gaining exposure to emerging markets did. While initial emerging market investment vehicles were generally broad-based, focus and specialization are the order of the day in this evolutionary period.

Recognizing that not all emerging markets are the same, options that allowed investors to focus on different regions emerged. Country and region-specific funds are now readily available. Options such as currency-hedged funds are also now available.

Other variations that mark developed markets, such as size and style, are now also offered in emerging markets funds. Small and mid-cap exposure is readily available as well as factor-focused funds, such as emerging markets value.

Thematic funds are also available such as consumer-oriented, technology, ecommerce, and internet-focused emerging markets funds.

Additionally, emerging markets exposure is now available in other related asset classes such as private equity, venture cap, real estate, hedge funds, and currency funds. Emerging markets fixed-income funds are readily available.

Additionally, EM 3.0 and beyond is seeing the acceptance of frontier markets, which may be thought of as in FM 1.0.

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Endowments at the Forefront of Emerging Markets Investments

According to a study conducted by Janus Henderson, endowments appear to have the most aggressive allocation to emerging markets equity, as the chart below highlights. 4

Source: Park Suny, Emerging Markets Equity: What Do They Know?, Janus Henderson, March 2018.

The report highlighted that, as of the end of 2016, Yale, Stanford, and Harvard had emerging markets allocations of 9.0%, 10.0%, and 11.5%. In all three endowments, the emerging markets allocations were greater than the allocations to U.S. equity.

The emerging markets allocation in defined contribution and public pension plans significantly lag those of endowments.

ALLOCATIONS TO EMERGING MARKETS

0.3 0.74.7

8.3 9.0

Perc

ent

% of Overall Plan

% of Equity Allocation

0

10

20

30

40

50

Yale EndowmentPublic PlansDefined Contribution

45.2

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Retail Investors Catching Up, But Still Lagging

Based on surveys conducted by the portfolio managers of the Emerging Markets Internet & Ecommerce ETF (EMQQ), financial advisors estimate that, on average, their clients have an 8.6% weighting in market cap, somewhat in line with the Yale endowment, but below the more aggressive Harvard allocation.

Source: EMQQ Internal polling sources from over 1,400 retail and institutional investors who chose to participate on webinars on the dates

indicated. Those particpants were asked identical polling questions.

However, where they may be lagging more aggressive plans is in their method of achieving this exposure. EMQQ’s surveys show that retail investors are primarily attaining their emerging markets exposure through broad-based emerging markets funds.

Thus, retail investors may be missing out on some of the potential opportunities that may be available in more specialized funds.

EVOLUTION OF EM ALLOCATIONS

0

10

20

30

40

50

60

% Using Thematic EM ETF% Using Broad EM ETFAverage EM Allocation

5.2%8.6%

47.0%

59.1%

1.5%

Perc

ent

11/2014 3/2019

14.6%

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How Much Emerging Markets Exposure Should You Have?

While the optimal allocation to emerging markets may vary depending on the risk and return objectives of investors, we believe that investors should hold “More” of their portfolio in the asset class than they currently do.

Why do we feel this way?

Equal Weighted Implies a Larger Allocation

According to an article in Wealth Management magazine, the market capitalization of the emerging markets was nearly 25% of total world market cap as of 3/31/18.5 Even more compelling was the fact that the GDP of the emerging markets was over 43% of total world GDP as of 3/31/19. Thus, investors, on average, need to increase their weighting in emerging markets significantly just to get to an equal-weighted basis.

Growth Potential

MSCI highlighted that economic growth in emerging markets exceeded that of developed economies since the 1990s. They also estimate that to continue at least until 2023.1 At the same time, once rampant inflation in emerging market economies has declined to levels more in line with developed economies. Additionally, the debt levels and current account balances have been more favorable than those of

Source: Brookings Research 2017, Global Economy and Development.Data for 2020 and 2030 represent estimates.

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Demographics also support the emerging markets growth thesis. According to Wealth Management, 87% of the world’s population lived in the emerging markets, while 90% of the population under 30 lived in emerging markets, as of 3/31/18.5 A larger, younger population may favor emerging markets economies over developed markets.

More Attractive Valuations

In their report, MSCI noted that the valuations of emerging markets have historically traded at discounts to those of developed markets. On a Price to Earnings (P/E) basis, the discount as of 1/31/19 is around its historical average. However, on a Price to Book (P/B) basis, the discount is below its historical average, signaling a potentially attractive entry point based on valuation.

Summary

Exposure to emerging markets has evolved since the introduction of the asset class. From a relatively small allocation to broad-based portfolios to more meaningful allocations filled by a wide variety of strategies, emerging markets have become a bona fide allocation in investors’ portfolios.

However, we believe that investors should hold more emerging markets in their portfolio. Emerging markets represent a large portion of total stock market cap and world GDP. Additionally, their growth prospects and valuations appear attractive.

The Emerging Markets Internet & Ecommerce ETF (EMQQ)

EMQQ fits squarely in EM 3.0. The fund seeks to capitalize on the opportunities for more focus in emerging markets funds by investing in stocks in the internet and ecommerce sectors within emerging markets economies.

Investors looking for a focused fund within the emerging markets space may be well-served to consider an investment in EMQQ.

1 Melas, Dimitris, The Future of Emerging Markets, MSCI, April 2019

2 Defining Emerging Markets, The Economist, 10/5/17

3 Endowment Investor, Emerging Markets 3.0, 7/21/11

4 Park, Suny, Emerging Markets Equity: What Do They Know, Janus Henderson, March 2018

5 Hanlon, Sean, Should Long-Term Investors Own More Emerging Market Equities?, Wealth Management, 8/1/18