Emerging Markets: Opportunity Beyond the BRICs

by Sally Lee, Helen Zhang, and Karl C. Mergenthaler, CFA
J.P. Morgan Investment Analytics & Consulting
helen.x.zhang@jpmorgan.com, karl.c.mergenthaler@jpmorgan.com

Emerging markets are becoming an increasingly significant part of the global economy and financial markets.  By almost any measure, the strength and growth of emerging market economies is impressive.  Yet, emerging market equities still comprise a relatively small percentage of global market capitalization and institutional investor portfolios.

In our view, institutional investors have been cautious in their allocations to emerging market equities, especially beyond the BRICs (Brazil, Russia, India, China).  Clearly, many investors recognize the potentially attractive return characteristics and diversification benefits of this asset class.  However, most pension plans and other institutions currently allocate less than 5% of their overall portfolio to emerging market equities.

The J.P. Morgan Investment Analytics & Consulting team reviewed the investment case for emerging markets.  We analyzed macro-economic data and trends for both developed and emerging markets.  Also, we examined the historical performance and correlation of returns for emerging market countries.  Finally, we considered the merits of active management in emerging market equities, as well as some of the inherent risks of the asset class.  In all, we believe institutional investors should consider establishing or increasing allocations to emerging market equities.

A Major Player in the Global Economy

In general, emerging markets are countries that are experiencing rapid economic growth and social change.  In order to understand the size and importance of emerging markets to the global economy, we analyzed the World Bank’s Gross Domestic Product data since 1960.  Over the past decade, the contribution of the United States to global GDP has declined from approximately 31% in 2000 to approximately 24% as of the end of 2008.  Meanwhile, the contribution of emerging markets to global GDP has increased from approximately 16% to 25%. In Exhibit 1, we illustrate the contribution of the United States, other developed markets, emerging market countries, and frontier market countries to global economic activity.

Exhibit 1: GDP as a Percentage of World GDP

Source: The World Bank, J.P. Morgan Investment Analytics & Consulting estimates

As shown, the contribution of the United States and other developed market countries to global GDP has stagnated over the past decade while emerging market countries’ contribution has increased steadily.  Currently, emerging market countries account for approximately the same amount of economic activity as the United States.

Importantly, the fiscal status of emerging market countries has improved dramatically relative to that of developed market countries.  Notably, government debt as a percentage of GDP is approximately 20% for emerging market countries, while this ratio is more than 60% for the United States, France, Germany and other developed countries.  During the recent credit crisis, the fiscal condition of emerging markets relative to developed markets shifted significantly in this direction.  In our view, this dynamic is likely to have major ramifications on currency values and economic competitiveness for some time to come.

In our view, demographic data further confirm the importance and potential long-term growth of emerging markets.  For example, according to the World Bank, emerging market countries currently cover 56% of the world population, while developed markets only make up approximately 14%; in addition, the average age in emerging market countries is much younger, as approximately one quarter of the population is between the ages of 0 and 14 years.  In the aggregate, emerging markets account for more people, at a younger age, than developed markets. 

Plenty of Investment Choices

There are a wide variety of active and passive investment vehicles available to access emerging markets.  Over the past two decades, emerging markets as a whole have grown from less than 1% of the MSCI All Country World Index in the late 1980s to more than 13% as of mid-2010. 

In addition to emerging markets, “Frontier Markets” have gained some attention among institutional investors.  Frontier markets consist of smaller and less prominent countries in an even earlier stage of development than emerging market countries. These countries may have high growth potential, but also high risks due to illiquid capital markets and political instability.  The MSCI Frontier Market Index attempts to represent the investment opportunity set with these 26 frontier market countries.

Active Management May Pay Off

In our view, there may be ample opportunity for active managers to add value in the emerging markets equity category.  In the J.P. Morgan Manager Universe, there are approximately 130 active managers in this category with a wide range of performance.  For example, among the active managers with a track record of at least 10 years, the top performers have generated annual returns in the high teens, while poor performers have generated low single-digit returns over the past decade.

Exhibit 2 — MSCI Emerging Markets Index

Source: MSCI, J.P. Morgan Investment Analytics & Consulting estimates (June 30, 2010)

According to MSCI, the MSCI Emerging Markets Index is a market capitalization weighted index that consists of 21 emerging market countries, as illustrated in Exhibit 2.  It is interesting to note that the components of the MSCI Emerging Markets Index have changed materially over time.  For example, the allocations to BRIC countries have grown from approximately 25.6% of the total index in 2000 to approximately 49.1% as of July 2010, as illustrated in Exhibit 3.

Exhibit 3 —BRICs

Source: MSCI, J.P. Morgan Investment Analytics & Consulting estimates

As shown, the MSCI Emerging Markets Index has become significantly more concentrated in the BRIC countries over the past decade.  However, our analysis indicates that active managers with strong long-term track records appear to be under-weight the large BRIC countries as of March 2010.  Perhaps these active managers are able to identify opportunities among emerging market countries that have not received as much public attention as the BRICs, such as South Africa or Thailand.  

Next, we analyzed the correlations of the individual countries within the emerging markets index.  Based on our analysis, the correlation of returns of emerging market countries to one another seems to vary widely.  In Exhibit 4, we summarize the average correlation of each country within the emerging markets index to the other countries.

Exhibit 4 — Low Correlation Among Emerging Market Countries

Source: MSCI, J.P. Morgan Investment Analytics & Consulting estimates

As indicated above, many of the smaller countries within the emerging markets index are not highly correlated with one another.  In our view, low correlations among the countries within the emerging markets universe may provide opportunities for active managers to pick long-term winners and avoid losers as well as to build portfolios that are more diversified than the index. 

In our view, investors must also consider management fees and transaction costs associated with active management.  The median fee for passive separate accounts averages 24 bps and passive mutual funds 57 bps, while active managers are more expensive at 93 and 130 bps for separate account and mutual funds, respectively.  In Exhibit 5, we illustrate the median fees for active and passive managers in the emerging market equity universe. 

Exhibit 5 —Management Fees

Source: eVestment Alliance, J.P. Morgan Investment Analytics & Consulting estimates

Additionally, investors can choose to invest in Exchange Traded Funds (ETFs) that closely track an index.  The fees for this method have a wide range dependent on the type and complexity of investment strategy implemented.  For example, broad markets ETFs tend to be at the lower end of the fee spectrum at approximately 25 to 30 bps, while more specialized and focused strategies carry higher expense ratios at approximately 75 to 100 bps.

Clearly, there are a number of qualitative issues that investors must consider when contemplating an allocation to emerging market equities. One of the most decisive factors is liquidity, as plan sponsors may shy away from markets with lower volume and smaller market caps.  Many of these issues are incorporated in the classifications of MSCI Emerging Markets Index, which consider economic development, size and liquidity requirements, and market accessibility. Per MSCI, market accessibility integrates qualitative measures reflecting the investment experience of international investors in a given market, focusing on liberalization, level playing field, competitive landscape, information flow, and stability.  In addition, emerging markets may involve a multitude of other political, social, legal and regulatory risks.

Conclusion

Based on our analysis of the economic data, it is clear that emerging markets have become a significant player in the global economy.  In sum, emerging market countries account for more than half the world’s population and one quarter of the world’s economic production.  The GDP per capita in emerging countries is a fraction of that for the United States or other developed countries.  But if emerging markets are able to close this gap over time, it should result in significant economic growth and a tremendous opportunity for investors.

In our view, the complex and relatively inefficient nature of emerging markets may lend itself to active management.  Our analysis indicates that the most widely used benchmarks have become more narrowly concentrated in a small number of well-known countries.  However, we believe the best active managers may be able to identify opportunities in smaller markets, and build portfolios that are more diversified than the index.  As such, manager selection is critical given the volatility in the asset class and wide dispersion of outcomes.  In all, we believe institutional investors should consider establishing or increasing allocations to emerging market equities.

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