The allocator’s perspective: three key decisions on EM equities

After a difficult 2022, the outlook for emerging market (EM) equities appears at last to be improving. While some challenges are likely to persist, we think lower relative valuations, a moderating US dollar and a more promising set of economic indicators are among the factors that point to a more constructive environment. From a wider economic perspective, it seems clear we are experiencing regime change — from a period of central-bank-led stability to an era of increased volatility and economic divergence between countries, which should foster greater asset price differentiation and potentially attractive investment opportunities. 

With this backdrop in mind, I’d like to share perspectives from iStrat, the investment strategy and solutions group within Wellington, on three decision points allocators should consider when it comes to EM equities: the role of active management, the construction of the EM portfolio and the use of thematic approaches to target structural trends in emerging markets.  

1. Why active management for emerging markets?

Increasingly, allocators we speak with are thinking not in terms of “active or passive” but are instead adopting a more nuanced approach to deciding where to spend valuable fees and how to combine passive, factor and active investment approaches. We believe allocation decisions should be based on several factors, including the extent to which market inefficiencies may create opportunities for active managers to outperform. It has long been asserted that emerging markets are among the most inefficient markets, and research by our Fundamental Factor Team backs that up (Figure 1). Another potential source of inefficiency is the fact that corporate governance standards vary widely across emerging markets, and active strategies that allow for more scrutiny of these issues may add value over time.

Figure 1

We also think the active/passive decision should be thoughtfully aligned with an allocator’s goals. Here, we believe there are several compelling arguments for allocating all or most of a portfolio to active strategies, including the fact that EM indices tend to be backward looking and may have country or sector exposures that don’t fit an allocator’s goals, as well as the relative expense of passive investment within EM compared to developed markets. (Read more on the active/passive decision here.)

2. How should EM portfolio construction evolve?

Our discussions with allocators have also revealed EM portfolio policies that have not always kept up with the times, including the extensive growth in the universe of EM strategies. Our Multi-Asset Team has created a framework that can be used to help structure EM equity portfolios given the wider range of implementation approaches available today. As shown in Figure 2, they’ve divided EM strategies into three categories: EM 1.0 (passive), EM 2.0 (core active) and EM 3.0 (differentiated active).

Figure 2

Building on the market efficiency work by our Fundamental Factor Team above, our multi-asset strategists are unconvinced that EM 1.0 — passive EM equity strategies — will pay off sufficiently in today’s world. Instead, their research suggests that EM 2.0 strategies and EM 3.0 strategies may be complementary, with strategies from the latter category potentially helping to improve returns while also reducing total portfolio volatility — in some cases, by being less tied to the economic cycle than the broad EM indices. Examples of EM 3.0 strategies include high-tracking-risk strategies, regional- or country-specific strategies, and frontier-market strategies, among others. 

3. Why consider thematic investing in EM equities?

Thematic strategies may be well suited to the EM portfolio construction framework discussed above. They can target structural trends shaping the opportunity set, without the constraints of backward-looking benchmarks. In our experience, a thematic approach to investing in EM can help balance a portfolio’s risk. Today, the financials and IT sectors contribute roughly 50% of the MSCI EM benchmark’s risk — benchmarks tend to be backward-looking, rewarding past winners. Investing in future themes can help bring more balance to the risk profile by balancing risks across themes, thus potentially helping achieve higher risk-adjusted returns and downside protection. Thematic investments may also help reduce a portfolio’s reliance on strong economic growth to drive strong returns, a point discussed in our recent paper on adding thematic investments to a multi-asset portfolio. In today’s uncertain macro environment, where we expect to see greater and more volatile cyclicality, this would seem to hold even more appeal. 

Our Thematic team has identified a wide variety of secular trends they believe are spurring innovation and disruption in the global economy and creating attractive thematic investment opportunities. In their latest update, they highlighted several current areas of research, including: 

Social inclusion — As the team put it, “After 30 years of declining returns to labour across economies, a fight back has begun.” Transitioning towards a more inclusive economic model will take years, but the team thinks greater redistribution of wealth, more progressive income taxes, greater social spending and other changes will follow, providing tailwinds for enablers and beneficiaries of this transition. Likely thematic beneficiaries include financial inclusion, health care provision and social empowerment.

Net zero — Russia’s invasion of Ukraine turned net zero into a geopolitical theme, and while the costs of transitioning to a net-zero world have increased as a result, so has the national security urgency to reduce dependence on fossil fuels. Likely thematic beneficiaries include environmental consciousness and energy efficiency.

Economic nationalism — The transition towards a multipolar world is continuing apace, with China playing a growing role. The team expects a shift in post-Cold War structural drivers: deglobalisation instead of continued global integration; institutionalisation of competing centres of power instead of geopolitical stability; and policy oriented towards broader national security instead of a sole focus on economic development. Likely thematic beneficiaries include smart data, automation & robotics and digital infrastructure.