Worlds Apart: The Case for Separating Emerging Markets from your International Allocation

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By: Natascha B. E. Willans, ABS Global Investments

While emerging markets may only represent 29% of the allocation of the international index, it deserves a far larger percentage of a manager's attention. Their diversity and inefficiency offer active managers an excellent opportunity for alpha generation, however, the magnitude and complexity of underlying markets require dedicated resources to extract this alpha.

This is an excerpt from NCPERS Summer 2023 issue of PERSist, originally published July 18, 2023.

While emerging markets may only represent 29% of the allocation of the international index, it deserves a far larger percentage of a manager's attention. These markets are too large, diverse, and complex to be managed as an afterthought. Equally, the cost in terms of forgone alpha potential is too high.

An Impossibly Large International Universe
Forty-five countries, 2,237 stocks.¹ The international equity universe as defined by the MSCI AC World ex-US Index leaves investors with an impractically large universe. The natural question is whether it is possible for even an experienced investor to cover such a large universe in appropriate depth. Faced with this dilemma, allocators are encouraged to rethink the universe and split it into more manageable sub-segments: emerging and developed markets.

Emerging Markets: An Increasing Part of International Markets
The steady growth in the size and importance of emerging markets should not be overlooked. As recently as 2004 these markets represented only 10% of the international index. The allocation has grown almost three times since then.² Similarly, the number of stocks within these markets have multiplied over four times in the past 20 years.³ While emerging markets today represent just under 30% allocation within the MSCI AC World ex-US index, they represent more than half of its countries and 59% of its stocks.

Each country has its own economic, political and market dynamics to be analyzed and each stock their own fundamentals to be dissected. So, while emerging markets have rapidly grown as a segment within international markets, managers trying to cover the full universe have generally struggled to expand their coverage at the pace of this evolution.


Emerging Markets Inefficiency & the Alpha Opportunity
It is generally accepted that emerging market equities are priced more inefficiently than developed market equities.  Not only are information asymmetries more significant, but in many cases the large presence of retail investors creates further opportunities. This backdrop makes emerging markets fertile ground for skilled active managers to generate substantial alpha via stock selection. However, for this inefficiency to translate into value, investors must have the time, focus and mandate to scour this large and complex universe to find these opportunities.

Pitfalls of a Combined Allocation
Without the bandwidth to perform appropriate diligence, many international strategies “make do”. In the past, we found that approximately 80% of international products were underweight emerging markets.⁴ Although all these strategies were benchmarked to an index that includes emerging markets, they were on average underweight the asset class by 28%.⁵ Further, when these products were able to generate alpha within emerging markets, it tended to be driven by style, country and/or sector bets, rather than stock selection.


Conclusion
Once an afterthought for most managers focused on international markets, emerging markets have grown to become a core part of the non-US equity universe. Their diversity and inefficiency offer active managers an excellent opportunity for alpha generation, however, the magnitude and complexity of underlying markets require dedicated resources to extract this alpha. Moreover, the rapid growth of these markets suggests that the challenges of covering the full suite of international countries in one mandate will continue to grow. We believe the best way to extract alpha from these markets is to separate developed and emerging countries and specialize.

About the Author: Natascha B. E. Willans is a Partner and Investment Analyst at ABS. She is responsible for sourcing and monitoring emerging markets equity strategies. Mrs. Willans has been active following and allocating resources to Emerging Markets Managers for over 16 years. Currently, ABS manages over $6.8 Billion, mostly on behalf of Pension Funds, Endowments and Foundations.

Prior to joining ABS in November 2013, she was an Executive Director in Goldman Sachs' Global Portfolio Solutions group participating in the oversight of multi-asset class investment portfolios and manager research and selection. She holds a BS in Finance, Marketing and Italian Language Studies from Georgetown University.

Endnotes
[1] Number of countries and stocks within the MSCI AC World ex-US Index as of May 31, 2023.
2 Emerging Market countries as a percent of MSCI AC MSCI AC World ex-US Index as of May 31, 2023.
3Refers to stocks within each stock market defined as an emerging market by MSCI, with at least $100M in market capitalization. As of April 30, 2023
4 Data based eVestment as of Q1 2023. Universe defined as all active products within eVestment's “All ACWI ex-US Equity” universe with over $100M in AUM. Universe filtered to include only products with a preferred benchmark of MSCI ACWI ex-US Equity, MSCI ACWI ex-US Growth Equity, MSCI ACWI ex-US Value Equity and MSCI ACWI ex-US Small Cap Equity. Considers data from Q1 2019 through Q1 2023.
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