Over the past couple of years, our discussions with investors have at times revealed emerging market (EM) portfolio policies that are stuck in the past — in some cases, policies that were established a decade or more ago. In that span, we’ve witnessed massive change in the EM universe, including a near doubling of China’s weight in the MSCI Emerging Markets Index from 17.4% to 31.4%.1
We believe the time has come for EM equity exposures to evolve. In this paper, we lay out a simple framework investors can use to structure their EM equity portfolios given the wider range of implementation approaches available today. We also address the active/passive decision in EM portfolios and offer ideas on the manager selection process.
Why do EM equity exposures need to evolve?
Emerging markets accounted for 11% of the MSCI All Country World Index as of 30 September 2022, up from just 5% as recently as 2004. As a result of this growth, investors trying to capture the global opportunity set today generally include EM equities, with the starting point for many being to size allocations to emerging and developed markets according to their weight in the global equity universe. Increasingly though, investors are looking beyond market-cap approaches and making sizing decisions based on valuations, expected returns, and other factors.
Our focus here is on the construction of the EM equity exposure once the sizing decision is made. Over the past decade, the universe of EM equity strategies has expanded greatly, and we believe EM equity exposures should evolve to take advantage of the many opportunities this universe provides to pursue attractive returns.
In the framework shown in Figure 1, we have broken the universe of EM equity strategies into three categories. EM 1.0 includes broad passive strategies that follow a cap-weighted benchmark. EM 2.0 (illustrated in more depth in Figure 2) includes “core active” strategies — that is, broad, diversified strategies that seek to take advantage of inefficiencies in emerging markets through bottom-up security selection or top-down country and sector selection. EM 2.0 may also include quantitative strategies, whose disciplined approach can be well suited to the large opportunity set and high transaction costs in emerging markets.
EM 1.0 and 2.0 strategies are already widely used by investors. Our framework pairs them with EM 3.0 strategies, or what we call “differentiated active” strategies. These are niche-ier strategies that tend to have less reference to cap-weighted benchmarks (higher tracking risk) and therefore may be more diversifying in a portfolio.