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The equity opportunity set for emerging markets (EM) has changed dramatically over the past three decades. When the MSCI EM Index was first introduced in 1988, the index represented 10 economies. Each of these could be roughly characterized as “underdeveloped, but growing rapidly.” Today, 24 economies are reflected in the index, and 44% of global nominal GDP and 80% of global GDP growth are attributable to EM.1
Surprisingly, though, our analysis of data from eVestment indicates that EM makes up only about 6% of investors’ equity allocation, which seems out of line with the influence of EM in global markets. And we believe that, as emerging markets continue to develop and become more integrated into global markets, their influence is likely to increase.
Adding enhanced strategies at the core
A traditional paradigm for portfolio construction has been the “core-satellite” construct, in which investors complement a pure market-capitalization indexed “core” with high active-share, fundamental stock-selection “satellite” strategies.
That said, however, we strongly believe that many investors could also benefit from allocating to so-called “Enhanced” strategies at the core of their EM portfolio. Enhanced strategies seek a modest amount of outperformance while aiming to replicate the risk characteristics of their reference indexes. They pursue this modest outperformance by taking very small active positions away from the benchmark.
Case for including active management
Developed market (DM) and EM factor spreads suggest that emerging markets are relatively less efficient – and therefore that specific investment themes are more easily exploitable in EM, compared with DM.2 Our analysis of smart beta factor spreads illustrates these inefficiencies.3 In particular, EM small-caps present a ripe opportunity for active management to drive outperformance.
China also invites attention because its A-share stock ownership is concentrated in the hands of retail investors.4 This should also lead to a less efficient market, which in turn may create greater alpha-generating opportunities for active managers. That said, we don’t think that investors should stray too far from a broad, active approach to China, which provides flexibility for managers to allocate dynamically across sectors, capitalization buckets and stocks.
“Optimized” EM portfolio allocations
Our optimized EM portfolio includes enhanced strategies alongside indexing at the core. In the satellite sleeve of the portfolio, we’ve included specific allocations to small cap and Chinese equities, as well as highly active, higher-tracking-error strategies. Based on these assumptions, we ran through a range of portfolio combinations to find an EM portfolio that was optimized for the highest information ratio (i.e., the ratio of excess returns to active risk). Our optimized portfolio, shown in Figure 1, has an active return of 1.16%, a tracking error of 0.80% and an information ratio of 1.44.
By relaxing some of our constraints, we also identified some portfolios with higher levels of tracking error and greater return potential, as shown in Figure 2. As we increase tracking error we tend to allocate away from index and enhanced strategies and toward highly active, small cap and China strategies. For example, a portfolio targeting around 2% tracking error to the EM benchmark might choose the distribution shown in Figure 2.
As emerging markets have developed, investors have many building blocks to choose from – index, enhanced, fundamental active, quantitative, thematic, regional, country-specific, and so on. We have looked at only a few key considerations that investors should consider as they build an effective EM equity portfolio.
We recognize that a final equity portfolio involves a wide range of considerations that are unique to each investor, including liquidity needs, fees and risk tolerance. We hope this article gives investors some of the tools they need to start thinking about portfolios equipped for the rising influence of emerging markets.
To request a copy of the entire whitepaper, “Optimizing Your Emerging Markets Equity Portfolio: Key Considerations” please email email@example.com
1For an in-depth discussion of this topic, see “Emerging Market Equities: No Longer Only Beer, Banks and Cement,” by George Bicher and Laura Ostrander (State Street Global Advisors, April 2019).
2See Optimizing Your Emerging Markets Equity Portfolio: Key Considerations by Altaf Kassam and Gaurav Mallik (State Street Global Advisors, September 2019).
4HSBC China Market Access Primer, as of February 2019.
Emerging Markets: 26 emerging economies: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and the United Arab Emirates.
Per Capita GDP: Per capita GDP is a measure of the total output of a country that takes the gross domestic product (GDP) and divides it by the number of people in that country. The per capita GDP is especially useful when comparing one country to another, because it shows the relative performance of the countries.
Important Risk Information
The views expressed in this material are the views of Altaf Kassam and Gaurav Mallik through the period ended September 23, 2019 and are subject to change based on market and other conditions.
This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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