Should investors examine 'emerging market' indexes?

With small-fry economies now grown into big fish, the diversification benefits of the label might be diluted

Should investors examine 'emerging market' indexes?

Proponents of diversification have long understood the need for investors to have international exposure. Taking it even further, many accept that assets from emerging markets can lead to faster growth and returns less closely correlated to those in already-industrialized countries.

But with the category already past its third decade of existence, it may be time for investors to re-examine its makeup — and whether it’s time for a shakeup.

“By 1987 … MSCI published its first EM stock index and the Templeton Emerging Markets Fund was launched, covering Hong Kong, the Philippines, Singapore, Malaysia and Thailand,” the Wall Street Journal reported.

The Journal noted that those five economies together had a market capitalization of just below US$100 billion that year; today, that has number has swelled to exceed US$2.5 trillion. And that does not include other countries that have since joined the emerging-market club.

The diversification benefits were plain to see during the 1990s, when the stocks tracked by the MSCI EM would beat and undershoot the developed-market World Index by 40 or 50 percentage points in some years. Over time, those differences have become less pronounced as many markets included in the category have grown into giants.

“Two of the key members of every major emerging-market index—Taiwan and South Korea … are now at least as rich as developed markets like Italy and Portugal in terms of purchasing-power parity,” the Journal report said.

Compounding the problem is the fact that some indexes cast wider nets. As a case in point, the J.P. Morgan Emerging Market Bond Index includes countries as wealthy as Qatar, which is richer than the US on a purchasing-power-parity basis. And when such indexes get picked up as a benchmark for index-based investments, they can start to behave more alike from a financial-market standpoint.

“Nations that don’t share the same economic fundamentals or market structure get inflows and outflows of capital at the same time because of their position in benchmarks like the MSCI Emerging Markets Index,” the report said, citing the Hong Kong Institute for Monetary Research.

The addition of Chinese stocks and bonds in emerging-market indexes creates an additional wrinkle. Considering the sheer size of the Chinese market, it would account for more than 40% of the MSCI Emerging Markets Index if it were given a full weighting based on its market cap. If one were to put together the other three members of the BRICs — Brazil, Russia, and India — they would account for only half as much.

“Investors would be buying into a more homogenous asset class where Beijing’s policy decisions mattered more than perhaps any other factor,” the report observed. “On the other hand, artificially limiting exposure to such a huge and still truly emerging country would make no sense either.”

The report suggested that rather than following the apparently outdated “developed vs. emerging” system of sorting assets, investors should look at more tangible investment factors such as volatility or growth prospects.


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