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The Evolution of Emerging Markets (Part 2)

While the makeup of the universe of emerging-markets stocks will inevitably continue to evolve, it is impossible to say what it will look like 10 years from now.

Ben Johnson 18/12/17

In part 1 of this article, we looked at how the emerging markets have changed over time. In part 2, we are going to look at what the future might hold.

What the Future Might Hold
While the makeup of the universe of emerging-markets stocks will inevitably continue to evolve, it is impossible to say what it will look like 10 years from now. That’s precisely why many investors choose to invest in this market segment using a broad, market-cap-weighted index fund. However, it’s safe to say that country membership and the level of access to previously closed markets will remain in flux.

For example, as part of its 2017 annual market classifi­cation review, MSCI announced that it will include China A-shares in the MSCI Emerging Markets and MSCI ACWI indexes (please see our article “MSCI Takes a Step to Bring China A-Shares Into the Fold”). MSCI’s decision, which follows FTSE Russell’s 2015 launch of China A-share inclusion indexes, is recognition of the significant strides China has made toward opening its capital markets to foreign investors in recent years. Exchange-traded funds and index funds tracking the affected indexes will add some or all of the 222 A-shares earmarked for inclusion to their portfolios and will ultimately respond to any subsequent steps that materialize as part of this longer-term road map toward bringing onshore Chinese stocks into the fold.

While the near-term implications of China A-share inclusion won’t move the needle much, it is a significant first step toward greater global integration of the domestic Chinese capital market. The initial A-share inclusion target represents a small weighting in the affected benchmarks (about 0.10% of the MSCI ACWI and 0.73% of the MSCI Emerging Markets Index). Ultimately, these moves will bring China’s standing in equity indexes more in line with the true footprint of the nation’s capital markets and its economy at large.

Also of note is the fact that both MSCI and FTSE have Saudi Arabia on their short lists for potential inclusion in their emerging-markets benchmarks. Further opening of the kingdom’s capital markets and the potential for an initial public offering of Saudi Aramco could have a significant effect on the character of the pool of emerging-markets stocks.

Implications for Portfolio Construction
Per MSCI’s definition, emerging-markets stocks represent about 7% of a globally diversified 60/40 stock/bond portfolio, at market weight. These stocks’ potential contribution to long-term returns is clear but will likely come at the expense of pronounced volatility. As is the case with international stocks more broadly, the prospective diversification benefits of an allocation to emerging-markets stocks may be limited and could even wane with time.

Exhibit 1 shows the rolling three-year correlation between the MSCI Emerging Markets and MSCI World indexes. As you can see, the level of correlation between developing- and developed-markets stocks has increased significantly since the 2001 launch of the MSCI Emerging Markets Index. This could be attributable to a number of factors.

More widespread recognition of the group as a distinct asset class and greater investment—particularly by foreign investors—could be partly to blame. Simultaneously, the degree to which these countries have become integrated in the broader global economy has unquestionably increased. To the extent that these nations’ prospects have forged stronger ties to those of more advanced economies, the greater degree of co-movement among their stock markets makes sense.

Also, growth in emerging markets has been a boon for many global firms that have stocks trading on developed-markets exchanges. The MSCI USA With EM Exposure Index selects constituents from the MSCI USA Index and weights them on the basis of the proportion of their revenues derived from emerging markets countries. The benchmark’s largest holding is Apple (AAPL, listed in the U.S.), which received a 13.62% weighting as of the end of September. This underscores the degree of connectivity between emerging and developed markets. It is unlikely this interdependence will diminish anytime soon. As such, it could mean that the correlation between emerging and developed markets will remain elevated and that the prospective diversification benefits of emerging-markets stocks will diminish from the perspective of a U.S. investor.

Key Takeaways
1 | Emerging markets are dynamic by definition. The makeup of this group will continue to evolve as these nations continue to either climb or fall off the economic development ladder.

2 | Expect a bumpy ride. These countries’ progress will be lumpy and their stock markets’ returns lumpier still. As always, reaping the prospective rewards of an allocation to emerging-markets stocks hinges on investors’ ability to buckle up and sit tight.

3 | Diversification benefits may dwindle. To the extent that emerging markets continue to integrate into the global economy, they may move in lock step with their developed-markets counterparts.

About Author Ben Johnson

Ben Johnson  

Ben Johnson is the Director of Passive Fund Research with Morningstar.