Is passive exposure no good for emerging markets?

Current indexes don’t accurately capture the opportunities and risks offered by developing markets, argue experts

Is passive exposure no good for emerging markets?

China has featured prominently in a lot of financial news headlines; for those following the investment-fund space, particularly the corners influenced by index exposure, the country’s growing presence in major benchmarks has led to much excitement. But one commentary warns that market cap-based access to China — and even to emerging markets in general — is nothing to be excited about.

“While passive strategies can be an effective way to access large-cap US equities, investing in EM is different,” wrote Justin Leverenz and Heidi Heikenfeld, two senior portfolio managers at Invesco, in a recent blog post.

The first issue, they argued, is that passive global equity products offer inadequate exposure to emerging markets. As an example, they noted that China accounts for 19% of global GDP, yet it represents just 3.8% of the MSCI ACWI. Focusing more tightly on EM doesn’t fully resolve the discrepancy: they said China even though makes up 45% of EM GDP, its presence in the MSCI EM benchmark is limited to 33%.

“On the other hand, the more advanced EM economies, Korea and Taiwan, contribute a combined 7% of EM GDP but represent a quarter of the MSCI EM benchmark,” Levenrenz and Heikenfeld said.

Another possible concern, they continued, is that emerging-market opportunities evolve faster and in a more non-linear manner than developed-market opportunities do. EM indices, they opined, are overly exposed to sectors reflecting historical drivers of EM growth rather than drivers of future growth. To illustrate, they pointed to the 15% weight of the energy and materials sector in the MSCI EM index, along with tilts to traditional industries like banks (18%) and telecoms (4%). But the benchmark seems to miss striking new growth opportunities from areas like healthcare (3%), tourism (0.8%), and education (0.6%).

“Third, since the benchmark is essentially market-cap-weighted, it mandates a significant exposure to large state-owned enterprises (SOEs), most of which have poor governance track records,” they said. SOEs reportedly command 42% of the MSCI China Index and 24% in the MSCI EM Index as of May 31, which creates a considerable ESG risk.

Finally, the note focused on the MSCI EM Index, which is essentially a large-cap index. The way it’s constructed exposes 70% of its assets in companies with market caps over US$10 billion; the problem with that, Leverenz and Heikenfeld said, is that large-cap names represent less than 10% of the investable opportunity in emerging markets.

“For this reason, we believe active management is a must for investors who want to broaden their range of EM market-cap exposure,” they said.


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