Today, emerging markets represent approximately 12% of the MSCI All Country World index. For money managers who benchmark their performance against global markets, it is important to have exposure to this geographic sector.
When I first started managing money for clients over 30 years ago, the only way to access emerging markets was through mutual funds. Back then, most portfolios had a heavy home bias. Investing outside of Canada was especially difficult within an RRSP due to the 20% limit on foreign content.
Fortunately for Canadian investors, these rules were gradually lifted and disappeared altogether as of 2005. At the same time, ETFs were making geographic diversification into areas like emerging markets much easier for portfolio managers. Not only were investment options growing, the cost of international investing was falling thanks to the low-cost structure of ETFs.
Today, the MSCI Emerging Market index represents 26 emerging market countries, with China accounting for the lion’s share at 37.5%. The next-largest countries in the index are Taiwan (14.6%), South Korea (13.4%), India (9.4%) and Brazil (4.6%).
When classifying a country as a developed or an emerging market, MSCI looks at three criteria: economic development; size and liquidity requirements; and market accessibility. These factors will change as a country evolves. For this reason, regular reviews are necessary. In order to limit potential market disruptions, MSCI will reclassify a market only if the change is considered irreversible.
Index providers use different classification criteria, which can lead to notable geographic exposure differences across market segments. One important example involves South Korea, which S&P Dow Jones Indices and FTSE Russell have classified as a developed market since 2001 and 2009, respectively. MSCI continues to classify the country as an emerging market.
South Korea is an advanced nation, but you can only buy South Korean won locally in South Korea — leading certain index providers to deem the market as emerging. Developed market currencies trade globally.
Some portfolio managers have dealt with this discrepancy by reevaluating their index provider and the benchmarking of their portfolio. For emerging market ETFs, this underscores the importance of knowing how the ETF is benchmarked. In this case, if having exposure to South Korea is important, an investor will need to seek an appropriate benchmark or obtain single-country exposure to South Korea.
ETFs now include many single-country options within the emerging market space. If a portfolio manager has a particular conviction on a single country such as China or India, a dedicated country index product like the iShares MSCI China ETF or the iShares MSCI India ETF can be used alongside a broad emerging market index product such as the Vanguard FTSE Emerging Markets All Cap Index ETF, which has a management expense ratio of 0.24%. Many investors who are bullish on China have opted for concentrated exposure to that country, without necessarily holding other emerging market positions.
Emerging markets are a dedicated position in the equities portion of all of my portfolios, with varying degrees of exposure depending on the risk profile of the portfolio. My balanced portfolio has approximately a 5% allocation and my growth portfolio ranges from 5% to 7%, with dynamic growth going up to 10%.
These markets can move very quickly and trying to time them is extremely difficult. I prefer to either overweight or underweight my position, depending on my level of conviction. If the research is compelling, I will add a dedicated country position. I am presently tilted to overweight for emerging market positions in all of my portfolios. I believe these markets are poised to benefit from the global post-pandemic recovery and a weaker U.S. dollar.
Emerging markets lack the transparency of developed markets and ethical investors can be deterred by political instability. For those clients, I like the iShares ESG Aware MSCI Emerging Markets Index ETF, which is benchmarked to the broad emerging market space and is optimized for a higher portfolio environmental, social and governance (ESG) quality score. Companies are screened and weighted based on their ability to manage ESG matters and by considering ESG-related risks, with some exclusionary screening.
One step removed from emerging markets are frontier markets, such as Bulgaria, Croatia, Kazakhstan, Nigeria, Sri Lanka and Vietnam. These countries tend to have smaller, less accessible and riskier stock markets than emerging markets. Investment risks in these areas are much like those associated with emerging markets 20 years ago: political instability, poor liquidity, inadequate regulation, substandard financial reporting and large currency fluctuations.
I have had my eye on frontier markets for several years. While I am interested in these markets, I am not yet comfortable enough with them to include them in my discretionary portfolios.
The “emerging” opportunities in investing will continue to evolve, in part thanks to the ETF wrappers that make them possible. Proper due diligence will be necessary at all times to understand the risk and rewards of expanding geographic diversification in an investment portfolio.