As an overall asset class, emerging markets may offer elevated return potential, especially when compared to developed markets. While investors tend to view emerging markets as a single asset class, major differences exist between the underlying markets. When evaluating emerging markets for a portfolio, investors should understand the nuances and complexities of this asset class.
Figure 1: Emerging Market Classifications
WHAT IS AN EMERGING MARKET?
Exactly what is an “emerging market” – and how is it defined? Is a country classified as an emerging market due to its gross domestic product (GDP), per capita income or other quantifiable metrics? Surprisingly, the answer is no, because no universal definition of an emerging market exists. The International Monetary Fund (IMF) and many index providers interpret the definition differently, leading to varied results.
As the chart above shows, consensus has been reached on the classification for most countries. However, there are a few areas of disagreement. While countries such as Pakistan, Peru and Romania are considered “emerging” by some groups, others categorize these countries as “pre-emerging” or “frontier.” The FTSE Russell Index considers Poland and South Korea as developed, whereas MSCI categorizes these same countries as emerging.
And the categorizations are frequently changing. For example, FTSE upgraded Romania to emerging in September 2020 and downgraded Peru to frontier in September 2021, while MCSI downgraded Pakistan to frontier in November 2021.
For the most part, these classifications are based on subtle nuances which will have minimal impact on the index’s composition and performance due to their small weights within the index. However, one notable exception is South Korea, which is currently one of the larger weights in the MSCI Emerging Market Index with an allocation of more than 12%. On the other hand, FTSE and S&P consider it a developed market country, so it isn’t held within those indexes.
The lack of a universal definition for emerging markets and continuously shifting categorizations within indexes make investing in this asset class more challenging. How can investors be sure they are choosing underlying markets that fit their goals and objectives? Let’s take a look at a few strategies that should be considered when including emerging markets in a portfolio.
PASSIVE IMPLEMENTATION: SIMPLE AND EASY?
Investors may think passive implementation would be a relatively straightforward approach, one in which they forgo any alpha potential and lock in cheap fees to get efficient beta exposure. But it’s not that simple. Due to the different methodologies and compositions of the indexes, plus a lack of universal definition for emerging markets, investors must decide what index to track and what provider to use. This decision can have a meaningful impact when it comes to performance. Tracking error will likely be minimal, so it’s something that would remain mostly unnoticeable when looking at a fund in isolation. However, absolute returns – or the returns that really matter to the bottom line – can be substantially different.
For example, let’s compare two of the most popular passive emerging markets ETFs: Vanguard Emerging Markets (VWO) and iShares Emerging Markets (EEM).
Vanguard utilizes the FTSE Emerging Markets Index while iShares utilizes the MSCI Emerging Markets Index – and the performance differential is stark. The ETFs show a 150 basis points (1.5%) difference over the most recent quarter and a difference of 450 basis points (4.5%) over the trailing year. The performance differential experienced here is meaningful and isn’t too dissimilar from what you might see when allocating to emerging markets in an active manner.
Figure 2: Performance (as of 3/31/2022)
So why is there such a big difference? This stems from the difference in methodology discussed earlier. Particularly, how the different indexes that each fund track define “emerging markets” and, therefore, what countries they invest in. The allocation effect, or rather what countries are excluded or included—and at what weight—has played a large role in the performance differential. For example, the absence of South Korea—roughly a 12% weight in iShares Fund—has benefitted Vanguard over this time period. In addition, the methodology for what stocks are included has played a role—FTSE holds roughly 500 more stocks than MSCI and this additional diversification has been beneficial for the Vanguard Fund as well. While these differences can seem subtle, the impact can be large.
These differences illustrate why it’s important for investors to understand which index their investment is tracking and if it aligns with their objectives, even when applying a passive investing approach.
IMPLEMENTATION: CHOOSE YOUR OWN ADVENTURE
While passive implementation of emerging markets within a portfolio isn’t as straightforward as it seems, it is still a viable strategy for many investors. In the following section, let’s compare the methods investors can use to invest in emerging markets and uncover the pros and cons of each approach.
