How have the weightings of emerging market indexes changed during recent years? And what does that say about the performance of stocks across Asia? Laurie Havelock finds out
The discipline of emerging markets investing – choosing investible targets in economies transitioning between developing and developed status – emerged in the 1980s after then World Bank economist Antoine van Agtmael coined the term. Since then, it has become a widespread investment practice as investors and asset managers seek to generate alpha from the opportunities of economic development, rising wealth and boosted consumption in such countries.
For investors hoping to gain access to these markets – but for whom the specialist knowledge of each emerging market was out of reach – index funds provided a key route in. Though there are many providers, since the turn of the millennium the MSCI Emerging Markets Index has been a constant benchmark of these economies’ performance, and a model for determining the next growth opportunity.
The composition of the index has altered during the past 20 years as the paths of the various economies that underpin it have panned out. Research carried out by State Street Global Advisors (SSGA) shows that China’s trajectory, perhaps unsurprisingly, stands out most: its weight in MSCI’s Emerging Markets Index swelled from 7 percent in 2002 to 16 percent in 2007 and 34 percent in 2020, boosted by the recent inclusion of more A-Share listed stocks.
At the other end of the spectrum, countries that were favored in 2002 – South Korea, Taiwan, South Africa, Mexico and Malaysia – have all seen their allocations fall in the intervening years. Between the MSCI Emerging Markets Index’s rebalancing on December 31, 2014 and December 31, 2019, South Korea’s rating fell from 14.3 percent to 11.4 percent, Taiwan’s from 13.3 percent to 12.1 percent and Malaysia’s from 3.8 percent to 1.8 percent. Instead, assets have been increasingly allocated to China, India and countries in the Middle East.
George Bicher, senior managing director and asset class CIO for global emerging markets equities at SSGA, says this is partly because it is becoming harder to equate a developing economy with potential growth. ‘Investors tend to look at emerging markets for growth,’ he explains. ‘But growth in the emerging markets space is often as elusive as it is in developed markets.’
Bicher cites research from the IMF in January. This predates the Covid-19 crisis but it projects that emerging economies will achieve 4.4 percent GDP growth. It also suggests that only four countries are expected to grow at an above-average rate: India, China, Indonesia and the Philippines.
‘There are many emerging market countries whose economies barely grow as fast as developed market countries,’ he says. ‘That’s not to say there aren’t good stocks in slower-growth emerging market countries, but it makes stock picking more valuable.’
Beer, banks and cement In fact, it appears that industrial trends have shaped growth far more so than national divisions. Once upon a time, emerging markets investment opportunities tended to be bundled together in very loose buckets: ‘beer, banks and cement’ was the term often used to designate those emerging markets assets that were generally the first to demonstrate sustainable growth.
Where banks, consumer goods companies and those that benefit from infrastructure contracts might be among an emerging economy’s early beneficiaries, leaders in the global technology sector are now the stars, whether involved in larger firms’ supply chains – such as Apple’s – or big names in their own right.
Since 2002 there has also been a broad rearrangement of the benchmark in favor of ‘new economy’ stocks. ‘China’s old-economy stocks tend to be large and often inefficient state-owned enterprises such as oil, gas and coal companies, while new-economy stocks tend to be private sector companies such as Tencent and Alibaba,’ write SSGA’s researchers. Indeed, Alibaba makes up 7.1 percent of MSCI’s Emerging Markets Index’s weighting in 2020, and Tencent 5.9 percent.
Bicher notes that the two shifts in MSCI’s index – geographical and industrial – are intertwined. ‘The change in the benchmark, with the increased weighting of Chinese companies and large technology companies elsewhere in Asia – such as TSMC (4.7 percent) and Samsung (3.9 percent) – has intensified the focus not only in Asia but also in the IT space,’ he explains. ‘Managing emerging markets mandates now requires a keen focus on technology, including both the aforementioned hardware names but also firms that provide IT-related services, such as Alibaba and Tencent.’
This rings true for Egon Vavrek, director of global emerging markets equities at Dutch pension fund APG Asset Management. ‘When I started 20 years ago, it was all about extractive and commodity firms,’ he says. ‘There has been an evolution toward the IT service sector and internet technology.’
Anchoring growth Though these shifts in MSCI’s index have been driven by particular corporate players, Vavrek warns that while the likes of MSCI are trying to adjust their products to ‘reflect the full potential’ of constituent countries, there is no guarantee that local governments and regulators will contribute to that growth, and some weightings may remain low.
‘I think some emerging markets economies are not doing themselves many favors,’ he adds. ‘Some capital markets are not opening up at the speed that was promised, and the return of some unlisted larger entities has skewed certain indexes and caused a headache for local authorities. That transition has been slow.’
Vavrek believes, however, that the ‘long-haul game is clear’ and that figures pertaining to population growth, GDP per capita and GDP growth point to clear winners in the near future. He also sees China’s heavy weighting – and other economies losing out – as a natural progression of how indexes are formed.
‘As developed market indexes are skewed by the weight of US securities, I think we will go in a similar direction with emerging market indexes, with China as the entry point,’ he says.
It has also taken some careful stimulation by the Chinese government, which is putting in changes to focus on things like fixed-income investors ‘that fit into a longer narrative’ of attracting more foreign capital. ‘The speed is the only question mark,’ Vavrek adds. ‘While the opening up is already there, it might take five to 10 years, but the trend will still be there.’
Richard Segal, senior analyst at Manulife Asset Management (Europe), says this evolution will continue in a natural vein as more and more constituent countries develop ‘more of an equity culture’. ‘Companies will therefore become more in tune with the index’s requirements, leading to more firms included that international investors have to become familiar with,’ he explains. ‘This applies to Asia across the board: frontier markets are becoming bigger, and more advanced economies are becoming more developed.’
Harsh times Though emerging markets are, by definition, full of potential, they do not necessarily have a proven track record, and can be fragile in the face of large macroeconomic shifts.
In the weeks that followed the spread of the Covid-19 pandemic, emerging markets stocks fell to a record valuation discount to US equities, according to data from the Institute of International Finance, as investors rushed to dispose of assets they saw as riskier. As of April 7, developing world stocks were traded at an average 7.8 times profits, on a cyclically adjusted price-to-earnings basis – a 65 percent discount to a ratio of 22.6 for the US market.
Given the ‘particularly harsh’ macroeconomic climate caused by the Covid-19 pandemic, Vavrek expects ‘some significant index changes’ by the end of 2020. His eyes are particularly on India, the ‘second-largest fish in the bowl’ in terms of economic potential.
‘Its population size is already on par with China, but India’s GDP is just a quarter [of China’s],’ he explains. ‘As long as there are no big mistakes from its government or regulators, it could be a fairly large index component in the next few years. There’s enormous potential in India for the 10 or so unicorns currently unlisted that could become the local Alibaba or Tencent, if they came to market.’
Vavrek adds that there are few other countries that could match China’s growth potential but suggests ‘star performer’ Vietnam could break from being a frontier market into an emerging superstar. ‘It has huge potential,’ he notes. ‘But it is unlikely to change the overall structure of emerging markets indexes.’
Segal says one of the key challenges for index investors will be that the bulk of their emerging markets portfolios are weighted toward South East Asia, which will be difficult to oversee while travel is heavily restricted. He feels it highlights a wider problem with these indexes: even if there are fantastic opportunities in other countries, if they have a small weighting they might not be worth dedicating time to visit.
Looking ahead, however, Segal says growth may be shared across sectors in Asia, if restricted to familiar countries. Firms involved in the ‘experience economy’ may be the true winners, or those in traditional sectors that pivot well to meet evolving consumer demands, particularly as the world could wake up to the necessities of working from home or avoiding overseas travel.
Emerging markets IR during a crisis >>
Richard Jones, senior vice president and head of IR at Indorama Ventures, says emerging markets indexes or other compiled products could face some changes in the near future in the wake of the Covid-19 pandemic.
'Rejigging fund weights is not unusual in times of crisis, as investors naturally want to protect themselves,’ he notes. ‘But a well-balanced portfolio takes into account the countries that will bounce back quickly and that means fund managers cannot discount Asia that much.’
So how can corporates respond? ‘IROs need to go digital as fast as possible, if they haven’t already, and explain to fund managers their crisis management plans,’ advises Jones. ‘Companies that have plans to keep their staff safe are much more likely to ramp up again quickly when the storm passes; investors need to know that these companies can rely on a complete and healthy complement of staff.’
This means taking a digital approach to existing IR mainstays. Jones says that while he would normally expect IROs to focus on roadshows to reassure any nervous investors or analysts, these will now have to go online. ‘Have a series of meetings with key fund managers in America, Europe and even Asia,’ he suggests. ‘The purpose is to give an honest opinion of the situation and position your company as one of the likely winners, if that is possible. If things look gloomy, investors will want to determine the chances of your company surviving and fighting on later. No one can say investors would be wrong to pull out, but will they keep looking at you and expecting you to show signs of a recovery? Have you positioned yourself as a company that knows what it’s doing?’
Jones also suggests asking key members of management – perhaps your CEO or chairman – to record personal videos to update the markets every week or two. Similarly to how some IR teams already use video blogging to keep in touch with constituents, these are an opportunity to telegraph an accurate picture of your company’s situation while also making it appear that executives are speaking directly to the market.
‘If the chief executive has little time on his/her hands in a crisis, then send a round robin to senior executives to discuss their divisions,’ Jones continues. ‘Everything should be carefully scripted by the IRO to ensure the message is that the company knows what it is doing and has a crisis management plan in hand. Calming investors is the key to success.’
