The past decade has been a dominant one for developed markets. For the 10 years to the end of July, the MSCI World Index showed an annualised gain of 9.61% in dollar terms. The MSCI Emerging Markets Index was up just 3.33% per year over the same period. There is also a divergence in valuations between developed and emerging markets. The MSCI World Index is currently trading on a forward price-to-earnings (PE) ratio of 20.6 times. The forward PE on the MSCI Emerging Markets Index is 14.9 times. For Laurium Capital’s Brian Thomas, co-portfolio manager on the Amplify SCI Balanced fund, identifying where the value lies is not, however, as simple as comparing PE multiples. For a start, investors need to be aware of what they are buying.
Currently, China accounts for 42% of the MSCI emerging markets index. Alibaba and Tencent alone make up nearly 13.5%. ‘If you roll back to 2010, it’s interesting to note that the China weight then was only 17%,’ said Thomas. ‘So over the last 10 years the China weight in the index has more than doubled, and I would wager that it will continue to increase over time. The reason for that is that China A shares have only recently been included in the emerging market universe, and as that grows the Chinese component of this index will become larger and larger.’ One of the consequences of this is that the weighting to many other markets, including South Africa, has grown progressively smaller.
Adding to this is that there is a significant concentration in the largest stocks in emerging market indices. Investors are currently expressing concern about the level of concentration in the US, but the issue is actually more prevalent in emerging markets. As the graph below shows, the level of concentration in the FTSE Emerging Index has shot up in recent years, even more rapidly than the concentration on Wall Street.
A third shortcoming, Thomas believes, is the nature of many of the larger financial and energy stocks in emerging markets.
‘We have a lot of state-controlled entities in these sectors that are listed,’ said Thomas. ‘And we all know that state-controlled entities are often run for the benefit of the state and not minority investors like ourselves.’
Thomas believes that it’s also important to consider where returns are coming from. The total factor productivity provides a measure of the growth in real output in economies, and the below graph shows how this has changed over time in emerging markets.
‘We’ve had some glory days in emerging markets in the past,’ said Thomas. ‘From the early 2000s through to the mid-2000s there was incredible total factor productivity, and that benefited the market.
‘Since then, the total factor productivity has come down. The only place in emerging markets where there are total factor productivity gains is Asia. The growth that everyone hoped to capture by investing in emerging markets has started to whittle away because the total factor productivity is not what it was.’
Laurium’s analysis of returns on equity shows that across almost all sectors gains have been greater in developed markets.
‘This is key in our analysis and one of the main reasons why we end up investing more in developed markets than emerging markets,’ said Thomas. ‘We are chasing that return.’
Too much and not enough
For South African investors, Thomas believes that it is also vital to consider the correlations between asset class returns. ‘One of the responsibilities we have in running a balanced fund is to generate a balanced outcome,’ he said. ‘What you don’t want to do in any balanced fund is have bets that are all going one way.’ As the below table shows, however, is that there is a high correlation between returns on the MSCI Emerging Markets Index and the FTSE/JSE Capped Shareholder Weighted All Share Index (Capped SWIX), at 90%. Even the correlation with the performance of Naspers is relatively high at 67%.
Where there is a lower correlation, is with the S&P 500 Index.‘One of the things that has kept us from putting part of our offshore allowance into an emerging markets index is the very high correlation that our own market has to that space,’said Thomas. ‘What we prefer is to invest in markets that have a lower correlation to our own equity index. And, over time, the S&P 500 offers that.Citywire - The Conundrum in Allocating to Emerging Markets