Rethinking the Role of Emerging Markets Investing in Portfolios

Although the long-term prospects for emerging markets are compelling, the near-term outlook is far from rosy and the "bear case" for emerging markets has prevailed for much of the recent past.  GDP growth and margins, which were so strong leading into the financial crisis, have declined.  Ample liquidity from developed markets fueled the boom in emerging markets subsequent to the financial crisis, but with the gradual tapering of quantitative easing in the U.S., the liquidity boost is no longer as supportive of risk taking.  

Last year's "taper tantrum" shook investors out of complacency, and the rotation away from emerging markets was striking.  Within emerging markets, liquidity conditions are far tighter than in developed markets as is earnings momentum.

Our caution about the near-term outlook informs our conclusions about the need to approach emerging markets in a more selective manner. For much of the history of emerging markets, broad-based rallies and crisis-driven crashes were mostly a top-down phenomenon.  As emerging markets mature, we expect emerging countries to increasingly de-couple from one another, and within countries, we also expect some degree of de-coupling. 

Emerging market countries have differing demographics, less synchronized economic cycles and varying levels of political and economic maturity.  Although emerging markets exited the financial crisis in superior fiscal shape than developed markets, some of that "advantage" has been squandered through poor economic or political decisions. 

"Desperately Seeking…."

Now, more than ever, the outlook for emerging markets is a nuanced one and selectivity is critical.  Counting on a rising tide to lift all boats may be replaced by a more selective approach in which investors seek country, company or thematic opportunities. Although we've relied mostly on passive equity investments in recent years, an approach supported by our review of past performance and risk, we've been revisiting our approach to investing in emerging markets equities.

Investing in emerging markets requires more selectivity as well as awareness that market sentiment can change rapidly with each new element of incremental information.  For much of the past decade, certain countries were beneficiaries of the "commodity supercycle," the boom in commodities fueled by demand from China, a falling dollar and rapid economic growth.  

The rising tide of growth tended to lift emerging markets as an asset class, with certain countries big winners along the way.  Opportunities in coming years are likely to be much different, with themes including the rise of the emerging markets consumer, urbanization and structural reform.  Commodity consumers rather than producers may be winners, a reversal of fortune from recent years that favored commodity rich companies.  Asset-light companies, big winners in recent times in the developed world, may replace the asset rich firms that have been the big winners in emerging markets. 

We think that tomorrow's opportunities lie outside the countries and companies that dominate most indexes, and that there will be clear winners and losers.  

It's illustrative to see the stark contrast between the positioning that dominates the emerging market indexes and active positions taken by emerging markets portfolio managers. For example, we compared the most widely used emerging markets index, the MSCI Emerging Markets Index with a popular emerging markets fund, the Harding Loevner Emerging Markets Fund. The differences are interesting and thought-provoking. 

Sixty-three percent of the MSCI EM index is concentrated in five countries—China, South Korea, Taiwan, Brazil and South Africa; less than half of the Harding Loevner fund is invested in those top five countries, and nearly a quarter is invested in smaller or frontier markets.  he size of companies included is also interesting, with the weighted average market capitalization of the index approximately $34 billion, and the Harding Loevner fund nearly 25% less. 

Active managers may also have pronounced sector differences from the MSCI index, which has more than 40% exposure to financial services and technology.Though the active approach may be a more volatile one, we expect interesting opportunities to come from smaller countries and companies.

Consequently, we currently are favoring active investments in the emerging markets asset class. Some countries are in much better fundamental shape than others, again supporting a more selective approach.  In recent times, we've observed currency pressures, deteriorating economic indicators and political unrest among emerging markets countries. The developed world has largely been fixated by fears of deflation, while countries such as India and Brazil are struggling with inflationary pressures.

We think that some countries are better positioned than others, while at the company level there are companies that benefit from current trends while others are more vulnerable.