At Fairlight Advisors, we have long advocated that a nonprofit endowment investment strategy include a well-diversified, global market portfolio which includes both equity and fixed income allocations to emerging markets.
The last five years of returns have been lumpy for Emerging Markets to say the least. While there were some bright spots such as China’s faster recovery from the pandemic in Q’3 of 2020, there were low spots such as the stringent lockdowns and zero covid policy in China in 2021 which have led to supply chain disruptions and slow GDP growth.
In talking to nonprofit clients over the past 6 months, some look at their emerging markets allocation and think “why do we hold it?” Or worse, “Has it ever performed well?” Even in my personal global market portfolio, I find myself shaking my fist at the EM returns and the place it holds in my asset allocation.
The response to these questions is to remind ourselves why nonprofit investors should chose a global market portfolio in the first place and why a global portfolio that attempts to limit home country bias is important. We have covered the merits of a Global Market Portfolio before so let’s dig deeper into EM. To start, what is the definition of Emerging Markets – in other words, which countries are in the considered “in” and which are “out”?
What are Emerging Markets?
Figure 1
Since Fairlight Advisors tends to implement its asset allocation strategy for nonprofit investors using passive instruments such as Exchange Trade Funds (ETFs), we will use MSCI’s definition of Emerging Markets since iShares Emerging Markets ETF (IEMG) tracks this index. Specifically, MSCI’s Emerging Markets index is used to measure the financial performance of companies in fast-growing economies around the world. The index captures large- and mid-cap companies represented across 24 Emerging Market countries. Representing 1,380 companies, the index covers approximately 85% of company shares available for public trading in each country, also known as free float-adjusted market capitalization. For a full list of all 24 countries listed in the index, you can view the latest Fact Sheet from MSCI here.
As you can see from the chart at the right (Figure 1), China is the country with largest weighting in the index at 32.04%, with combination of “other” countries at 22%, followed by Taiwan (14.83%) and India (13.96%). The MSCI Emerging Markets Index started in 1988 with just 10 countries and 1% of world market capitalization to 2022 where it represents 13% of the world market capitalization with 24 countries.
Emerging Markets are NOT Frontier Markets
Emerging markets are not Frontier Markets, which are smaller, less developed capital markets, and somewhat riskier than Emerging Markets. They are sometimes referred to as “Pre-Emerging Market” countries. Despite their increased risk, Frontier Markets are still investable and are attractive to investors looking for long-term returns with the assumption these countries will become much more stable and established over time. The MSCI Frontier Markets Index captures large- and mid-sized companies represented across 28 Frontier Markets (FM) countries. The index includes 99 companies, covering 85% of the total market in each country. For a full list of all 28 countries listed in the index, you can view the latest Fact Sheet from MSCI here.
Figure 2
As you can see from the chart on the left (Figure 2), the combination of the “other” countries in the index stands at 35.63%, with Vietnam dominating as the largest country within the index at 30.71%, followed by Bahrain at 9.35% and Morocco at 9.28%. Fairlight does not currently invest in Frontier Markets as a stand-alone asset class since it represents a small portion of the world market capitalization currently. However, MSCI has moved countries from the Frontier to Emerging Markets index over the years such as when they reclassified Kuwait from Frontier to Emerging in December 2020. MSCI works on a rules-based system which has a framework of criteria: 1) economic development (for developed markets only) 2) size and liquidity 3) market accessibility. Prior to this inclusion, Kuwait had begun opening its economy and providing increasing access to international institutional investors, including strengthening its banking rules through its Market Development Project which began in 2017.
Related to the current crisis with Russia, MSCI announced on March 2nd of this year that it was reclassifying its Russia indices from Emerging Markets to standalone market status after a majority of global-market participants confirmed the Russian equity market is current un-investable.
Why invest in Emerging Markets Equity?
Now that we know the definition of Emerging Markets, why do we invest in this equity asset class to begin with? Why shouldn’t nonprofit investors just maintain an equity portfolio allocation to the US and Developed markets since those tend to be more transparent, liquid and mature?
Thirty plus years ago, when the Emerging Markets index just represented 10 under-developed but fast-growing economies, it was seen as an asset class that performed very differently from other markets and was even viewed as “outside” the core of a portfolio. Today, as the EM size has grown in global markets, an allocation to EM is seen as part of a “core” portfolio.
Despite recent underperformance in the past 2 years, there is a case for long-term growth potential and investment in Emerging Markets Equity:
- Economic Growth: The economies of Emerging Markets countries such as those in the index like China, India, Taiwan and South Korea have been fast-growing with future, strong earnings potential.
- Lower Correlation: In investing, correlation is typically a statistic that measures the degree to which two securities or asset classes move together. Both among EM Countries and across other asset classes, there has been a lower correlation which makes this asset class attractive when trying to build a global market portfolio. Meaning across EM Countries themselves and among other asset classes, they tend not to move up or down as closely together as say US Large Cap and US Mid Cap might.
- Opening Economies: Since countries like Saudi Arabia and China have become increasingly open to foreign investment, the EM indices allow investors access to these previously unavailable markets.
Figure 3
Even though returns in EM were down -2.2% in 2021 and down -20.77% as of September 1, 2022, the chart to the right shows (Figure 3) EM has dropped less during the 2020-2022 time-frame than developed markets. There are several factors to understand about Emerging Market Returns:
- Commodity Prices: Those EM markets which have a higher orientation towards energy and materials such as Latin America, the Middle East and Africa have already shown a positive return.
- China: Since China represents 32% of the EM index, the zero-COVID policy restrictions, regulatory crackdowns (e.g., Tencent and Alibaba), property market struggles and delisting of Chinese stocks (Sinopec, China Life Insurance, etc) have created significant headwinds on the EM index this year. Despite these issues, Chinese officials have signaled they will boost infrastructure spending to meet GDP target of 5.5% and stated they must support the technology sector in a move that appears they will reign in new policy regulations (for now). The government also approved 60 new online gaming licenses.
- EM Valuations: Currently, EM stock prices are trading at a 30% discount, meaning EM valuations are 30% cheaper than developed markets and offer investors a higher dividend yield than both the developed ex-US and US markets. There has been myths that EM equities don’t provide good dividend potential as they are high-growth stocks such as Tech or Pharma that don’t pay dividends. However, as EM markets have matured over the past 15 years, both the percentage of dividend paying companies has increased at a faster rate than developed market peers and the yield from these companies has been higher.
Figure 4
As the chart on the left shows (Figure 4), the EM high dividend has grown at a faster rate than the MSCI EAFE and MSCI US High Dividend indices. MSCI’s definition of “high dividend” is “set of companies with high dividend income and quality characteristics that pass dividend sustainability, persistence and quality screens.”
Why invest in Emerging Market Debt?
Since we defined Emerging Markets at the beginning of this article, we should delve further into Emerging Markets debt since it is more nuanced than Equity. At Fairlight, we split this asset class further into EM corporate and EM government debt. In the case of the EM corporate debt, the bonds included in this fund must be either: a) headquartered in an EM Country, or b) have 100% of the issuers’ assets in the EM economies, or c) be 100% secured by assets in the EM economies. While the corporate debt index methodologies are different from equity, the DM country coverage for corporate bonds is similar to that defined by MSCI’s EM equity.
Fairlight separates the EM government debt from corporate debt in much the same way we separate US corporate and government debt. We invest in both to allow for increased diversification and revenue opportunities. Because countries can increase taxes or cut government spending to meet debt obligations, there is slightly less risk than corporate EM debt and therefore slightly lower return opportunities. As an asset class, EM is closer to High Yield as the chart in Figure 5 shows than US or Developed Fixed Income.
Figure 5
Emerging Markets debt has been particularly frustrating these past 18 months as inflation took hold, the US began tightening monetary policy and the dollar gained strength. Each event by itself would cause the EM debt markets to come under fire but all of these has caused one of the worst price declines for EM debt in history. However, while EM debt is prone to large losses, it is also prone to rebounds that allow this asset class to reward the well-diversified investor. Looking at Figure 6, we can see that steep losses, defined here as drawdowns, have been followed by higher returns for this asset class.
The case to for nonprofits to continue investing in both corporate and sovereign emerging market debt is as follows:
- High Cash Buffers at EM Companies: Re-financing risk at a higher interest rate will be concentrated into specific sectors such as Chinese Real Estate. While it will be more expensive to finance debt in the future, companies with higher cash buffers can withstand this increase.
- Sovereign Spreads: Historically, when sovereign or foreign government bonds offer income yields 5% over US Treasuries of the same maturity, this signals potential buying opportunities. After the crash of 2008, the following year represented a strong buying opportunity and sovereign bonds rallied over 84% between 2009 – 2013.
- EM Rate Hikes Began Sooner: Emerging Market Central banks were ahead of their north American and Continental European peers in raising interest rates. In some countries, the tightening cycle is near its end which allow for longer duration opportunities and the ability to pick up more yield. Brazil, Chile and Colombia began rate hikes last fall, however these countries’ central banks are expected to stop raising rates soon.
Figure 6
While we have laid the case for Emerging Markets and there are signs pointing to higher return expectations in this asset class in 2023, it doesn’t mean we love it.
Or rather, we still get to love hating it due to our own lack of comfort with sovereign debt and our home country bias. Nonetheless, Emerging Market Corporate and Sovereign Debt represent an important diversification of a Global Market Portfolio and we will continue to allocate to it.
Talk to the financial experts at Fairlight Advisors to learn more about managing your nonprofit’s investments. Schedule a free consultation today!
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