Today, emerging markets (EM) and emerging economies represent about 45% of global GDP, but their share of total equity markets is about 30% and around 16% of fixed income markets. When it comes to equity benchmarks, such as the MSCI, the MSCI EM is only 12% of the MSCI All Country World Index, and in fixed income, EM debt is only 7% of the global debt markets.

Alan Ayres, Schroders’ London-based head of emerging markets strategic capability, sees the term EM as a helpful catch-all label, though with a significant caveat. The term can hide the heterogeneity – the diversity in character or content – that exists in these markets. Given these differences, investors need to be aware of the distinction between emerging markets and emerging economies, when considering an EM investment.

“It’s not that it’s an outdated term necessarily, but you’ve got to dig a little deeper than relying on a blunt grouping to really get the benefit of investing in what is a very diverse asset class,” he said.

Alan Ayres, head of
emerging markets
strategic capability

THEORY Vs. REALITY

EM growth certainly appeals to investors, but the belief that dynamic growth alone will eventually see these nations catching up with developed markets may be unwarranted. A significant point for investors to consider is the theory of convergence. Dating from the 1950s, it assumes that emerging nations will become developed markets, a process that creates vigorous growth and opportunities for higher returns.

As Ayres points out, the link between economic growth and market performance is tenuous at best.

Key reasons for this disconnect include unreliable GDP data, the share of profits from GDP can vary, particularly if an economy has a big export exposure, share issuance and IPOs, and the lack of representation, for example, public markets particularly in emerging economies such as Mexico, are not necessarily a good reflection of underlying economic structures.

“If you look at GDP per capita in China from the early 2000s until now, it’s gone from around $1,000 GDP per capita to about $9,000 today, a huge increase. But compare this with the GDP per capita in Japan of $40,000 and the US of $60,000. China has to grow at a little over 5% per year to 2035 to get to a $20,000 GDP per capita level,” Ayres said, pointing out also that an ageing population brings uncertainties to China’s trajectory and productivity growth is critical if China is to avoid being caught in the middle income trap.

Obviously strong economic growth is positive, but it may not always equate to strong market returns. “It’s more a question of monitoring economic and market development in terms of the sort of exposure one might want to take to that particular economy. Convergence is just one strand that investors need to think about,” Ayres said.

But opportunities certainly do exist. In equities, Schroders currently sees opportunities in markets like Brazil, Russia and Korea, but is less keen on India and South Africa, viewing India as an exciting long-term opportunity, albeit relatively expensive at the moment.

There are many different ways to approach EM, but given the range of opportunities and the current cycle, simply buying the index is unlikely to provide the best outcome for many investors.

"We think active management is the way to invest in EM markets because they are so diverse. There's lots of value to be extracted if you know what you are doing, and if you can navigate the complexity," Ayres said.

DIFFERENCE MADE BY DIVERSIFICATION AND KNOWLEDGE

Schroders, which was established in 1804, is a prominent investor in EM, managing about $80 billion in a variety of asset classes for its global clients. In Ayers’ opinion, one thing that differentiates Schroders from others in this space, is the diversification offered within its strategies.

“We’re not just one of the biggest investors in EM, we’re one of the most diverse. We have around 130 investment professionals dedicated to EM, spanning equity, fixed income, private equity, multi-asset and quantitative products; with over 35 different strategies,” Ayres said, adding that having such a variety of propositions and being able to span everything from fixed income to private equity, allows Schroders to focus on client outcomes and delivering solutions, rather than focussing on products alone.

Although EM equities still look cheap relative to developed markets, Ayres points out that earnings are being revised down, partly due to the US dollar, trade tensions and a general weakness in global growth.

“Is this a good time to be investing in EM? There’s a lot of uncertainty around – but there’s always uncertainty – and with uncertainty there comes opportunity,” Ayres said.

CHINA OPPORTUNITIES

Last year the MSCI added China’s A-share (onshore) stock market to its global equity benchmark, an exciting move that has many investors rethinking their onshore equities allocations. Although the weight in the MSCI EM Index is still relatively modest, one question is how to treat A-shares in an overall EM strategy.

Ayres suggests one potential approach is to have a separate China A-shares strategy – as a satellite exposure – on top of an existing EM exposure, an alternative that provides both access and flexibility.

“A typical EM fund is not going to give you very much China A-share exposure, although investors will likely have plenty of exposure to offshore China shares, as they represent around 30% of the MSCI EM Index. Even when China A-shares in the MSCI index increase to around 3.5% later this year, a traditional EM fund that is managed against that benchmark is unlikely to have a significant exposure to China A-shares, although it might if it’s a really aggressive fund,” he said.

Depending on what a client is trying to achieve, this alternative strategy of bolting on a China A-shares fund satellite to an EM fund creates a combination that would have delivered an improved risk-return profile, based on historical data.

Depending on the client, exposure to China’s opportunities could be treated as a standalone allocation, as part of a regional allocation, or part of a broader EM allocation. For example, Ayres suggests a satellite exposure might suit some institutional investors and by partnering with Schroders for its EM expertise can create a customised combination of a dedicated China A-shares strategy with a standard EM exposure.

“It’s important for clients to think about what they are trying to achieve. We help them achieve that outcome or find that solution for them,” Ayres said.

Please click here to learn more about a new approach to investing in EM.

Chart: Significant alpha in A-share market

IMPORTANT INFORMATION

The views and opinions contained herein are those of the author(s), and do not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document is intended to be for information purposes only and does not constitute any solicitation and offering of investment products. Investment involves risks.