Misrepresenting emerging markets

By Jack McGinn

Emerging market indices are poor representations of the investment opportunities available in that asset class. This arises in part because the index includes countries which are no longer emerging and omits some which manifestly are.

Emerging market indices are poor representations of the investment opportunities available in that asset class. This arises in part because the index includes countries which are no longer emerging and omits some which manifestly are.

Readers would have no problem naming countries considered ‘core’ emerging markets: China, India, Brazil, Mexico. Lots would surely utilise the ‘BRICs’ misnomer. But how about Vietnam? Or Israel? It’s very tricky to compile a definitive list of which countries qualify as ‘emerging markets’ and which don’t.

Which countries are in the index is far from academic. Investors in emerging markets, and particularly retail investors purchasing exchange traded funds which mirror the index, have a particular conception of what they’re buying. That is, access to markets where, in theory, there is scope for higher returns if investors are willing to tolerate potentially higher risk.

Investors in the asset class typically seek to benefit from the tailwinds around hundreds of millions of people being lifted out of poverty via globalisation, through the allocation of capital to companies which are contributing to and benefiting from sustainable development.

Yet this is hardly a truthful representation of the constituents of the index. Most prominently, Korea and Taiwan are not countries characterised by youthful populations, rapid urbanisation, a shift from agriculture to industry and an emerging consumption-driven middle class. They went through those transitions years or even decades ago.

Rather, these are societies where the median age is higher than the U.S., GDP per capita is higher than Italy and life expectancies match those of Denmark. On the UN’s Human Development Index (HDI)[1], both are very firmly ‘very high human development’ societies. Indeed, both have levels of human development higher than that of the UK.

Yet emerging market indices typically allocate a quarter of their assets to Taiwan and South Korea, countries not yet reclassified as developed markets based purely on the basis of technicalities around market access.

Meanwhile emerging markets investors struggle to access large developing country markets like Vietnam, Nigeria and Bangladesh, which are quickly integrating themselves into the global economy and ‘emerging’ as viable, long-term investment destinations. These ‘frontier’ countries are firmly emerging markets in socioeconomic terms.

This situation results in investors missing out on long-term investment opportunities. Equally, those countries excluded by EM indices are overlooked for portfolio flows which can help contribute to long-term socioeconomic development.

This is only one, albeit pertinent, example of the absurdity of investing according to any index, for the simple reason that they are necessarily backwards looking. Both in terms of companies and countries, they are composed of yesterday’s winners, not tomorrow’s. Investing through indices is akin to driving along a road by looking in the rear view mirror.

The concept of exchanges falling into categories such as developed or emerging is, moreover, a diminishingly cogent notion. Companies can increasingly choose which geography in which to list, be that Chinese entities in New York or Russian companies in Hong Kong. More and more businesses are truly global, and are either listed in developed markets but derive a significant portion or even a majority of earnings from emerging markets, or vice versa.

The index thus bears little resemblance to the opportunities available to investors in emerging markets. Especially so when indices include countries which no longer benefit from the strong sustainable development tailwinds which supposedly will be the driver of potentially higher returns in emerging markets whilst excluding some which do.

Bottom-up stock-pickers should not be hamstrung in searching for returns for their clients by arbitrary indices. The fact is businesses do not run themselves in line with indexes; asset managers should not allocate capital or define risk on such a basis.

Jack McGinn is an analyst at First State Stewart, the autonomous business within First State Investments which specialises in Asia Pacific, emerging market and global equities investing