As emerging markets have grown in size and importance, emerging market equities have become a core part of many portfolio allocations. In addition, the increased diversity and liquidity of emerging equity markets have made strategies commonly used to manage developed market portfolios (such as tactical allocations across regions and size segments) much more accessible to emerging market investors.
Despite these trends, the use of more complex asset allocation strategies within emerging market equities remains quite limited, as the vast majority of market participants continue to gain exposure to this asset class either via index-linked products that track traditional benchmarks or through active managers with mandates closely tied to those benchmarks. While accessing emerging markets through a single holding linked to a conventional benchmark can be an effective, low-cost way to obtain unbiased exposure to this asset class, evidence indicates that using a more discerning approach to managing emerging market portfolios may potentially add value in the same ways it can in the U.S. and other developed markets.
ALL EMERGING MARKET BENCHMARKS ARE NOT CREATED EQUAL
While most broad emerging market benchmarks tend to be highly correlated, there are methodological differences that can result in substantive performance differentials over time. Therefore, it is important to understand how emerging market benchmarks are constructed. For example, in the trailing 15-year period ending Feb. 28, 2018, the S&P Emerging BMI gained 580% on a cumulative total return basis, while the MSCI Emerging Markets Index gained a comparatively smaller 540% for the same time period. Analysis shows that the difference in performance was driven by two main factors. First, the MSCI Emerging Markets Index has an approximate weight of 15% in South Korea, while South Korea has been ineligible for the S&P Emerging BMI since 2001, when it was reclassified as a developed market. South Korea has underperformed 11 of the 16 countries that have been classified as emerging markets by S&P Dow Jones Indices over the 15-year period studied. Second, the S&P Emerging BMI has significantly broader coverage, including large-, mid-, and small-cap stocks, while the MSCI Emerging Markets Index includes only large- and mid-cap stocks. Over this period, the S&P Emerging SmallCap outperformed the S&P Emerging LargeMidCap by more than 146%.