CPD: Comparing the role of Emerging Market equities with World Small Cap equities

Emerging market equities can add value to investors’ portfolios.

Emerging Markets present an enticing proposition for global asset allocators, boasting a blend of growth potential and diversification advantages. EM specialist Ashmore Investment Management, a PAN-Tribal Asset Management investment partner, examines the role Emerging Market equities can play within a global asset allocation strategy framed through a comparison with World Small Cap equities.

The need for well diversified global asset allocations has rarely been so relevant. The world has become more multipolar, the health of global economies more divergent and stock market performance more concentrated, typified by seven US technology stocks contributing to over 60 percent of 2023 S&P 500 returns. Both Emerging Markets equities (EM) and developed markets small cap (World Small Cap) complement global asset allocations, yet their respective roles in global portfolio construction could not be more different.

High returns, low correlations

There is a range of similarities between EM and World Small Cap equities. In performance terms, the results are broadly similar. Over the past two decades, both the MSCI EM index and the MSCI World Small Cap index have returned between 7-8 percent in US dollar terms on an annual basis.

In addition, both EM equities and World Small Cap equities are ‘inefficient’ from an investment perspective, as the prices of EM and World Small Cap companies may not fully reflect all available information. This creates opportunities for significant alpha generation.

At first glance, both EM and World Small Cap also have similar risk characteristics characterised by high volatility. This, however, is an oversimplification and their risk profiles are highly differentiated. EM display lower correlations with Developed Markets (DM) and can diversify global allocations. Conversely, World Small Cap equities typically amplify DM equity returns, which is reflected by a market beta consistently above 1, as shown in figure one. During times of market stress, market correlations for both increase, although this is temporary in nature.

Too big to ignore and heterogenous

EM are a significant, diverse and global universe of countries that are undergoing periods of structural change and economic reform. In common is their often-earlier stage of development than developed markets, less mature institutions, as well as their often-overlooked nature.

EM attributes often include attractive demographics, rising per capita income, low penetration of goods and services and improving institutional frameworks.

• EM comprise 84% of the world’s population^[1]
• EMs hold 72% of the world’s foreign exchange reserves^[2]
• EMs have been a major driver of global growth over the past decade, contributing 66% of global GDP growth^[3]

EM countries also display a high degree of heterogeneity. Each has its own balance of growth drivers, and each are at their own distinct stage of development. This results in low intra-correlations within EM, which provides portfolio construction advantages and diversification to global asset allocations, as figure two demonstrates. In short, EM equities are an asset class too big to ignore and, as a primary driver of future global economic growth, warrants a significant investment allocation.

Structurally high returning investments

EM’s range of structural growth drivers result in faster economic growth than the developed world. All else equal, this attracts increased trade and capital flows, it enhances business activity and improves the backdrop for corporates to grow earnings. It is logical that such a backdrop should also be supportive for EM stock markets.

This has borne true historically at an aggregate level, especially when EM’s ‘growth premium’ compared to developed economies expands sustainably. Currently this is forecasted to occur. The IMF estimate EM real GDP growth to be 4.1% in 2024 and 3.9% in 2025, which is around 2.7% faster than advanced economies, and twice the magnitude compared to 2022.

Many EM companies operate in fast-growing and transformative economies that also often benefit from underpenetrated industries facing limited competition, resulting in sustainably high rates of return and long runways of growth. As a consequence, EM companies often display higher returns on equity (figure three), particularly those high-quality companies that can nurture their competitive advantages. The compounding nature of these high returns can drive long-term stock market performance and its mispricing can also be a source of price inefficiency as well as the opportunity for alpha generation.

Past performance should not be taken as an indicator of future performance

Richly diversified

The EM investable universe is richly diversified, which can be considered through different lenses.

EM offer investors exposure to dominant, well established and global leaders in industries with structural growth tailwinds. For example, EM companies dominate the supply chains behind Artificial Intelligence and energy transition, as well as other more specialist industries such as biologic drug development.

EM also include companies that are more domestic in orientation and benefit from structural consumption drivers such as increased financial inclusion and improved health and wellbeing. There are also more traditional exposures such as commodities, where EM dominate the supply chain for increasingly significant raw materials such as copper, polysilicon and lithium, among others. Many of these exposures are unique and cannot be gained in DM, and typically, they also are priced at more attractive valuation levels and have a longer runway for growth.

To illustrate this point, figure four provides a snapshot of the ‘thematic’ representation of an EM portfolio.

EM companies are also diversified by their differentiated balance of growth drivers, which can be framed as ‘rapid’, ‘mid’ and ‘cyclical’.

Each growth profile behaves differently at different points of the market cycle and diversifies portfolio risk if combined. For example, ‘rapid growers’ are companies with strong innovation and significant secular growth prospects. This is often, but not always, dominated by smaller companies (which would dominate World Small Cap). ‘Mid growers’ have much more dominant industry positions and high visibility of sustainable growth. While ‘cyclical growers’ may have strong near-term growth prospects yet sit in inherently cyclical industries with lower long-term visibility. There are of course also ‘low growers’ but these tend to be less interesting long-term investments.

As figure five illustrates, at a sector level, EM equities tend to dominate sectors that are markedly different to those available within World Small Cap equity. World Small Cap equity has more exposure to Industrials, Real Estate and Healthcare than EM equity. These industries tend to show high global cyclicality, which explains World Small Cap’s persistently high beta.

By contrast, as well as more domestic-orientated companies, EM equities offer a broader range of investment opportunities, including established world-leading companies across several industries – such as IT, Financials, Energy and Materials, that are set to determine the growth of the global economy.

EM should not be confused with small cap investing

The EM equity investment opportunity includes more than 3,500 stocks with the largest stock market capitalisation at USD 540 billion and the smallest at USD 24 million. By contrast, World Small Cap equity is around 4,000 stocks with the largest stock being USD 16 billion. The average EM stock market capitalisation is three times larger than the average World Small Cap.

Small Caps investing, both in EM and in DM, offers attractive investment opportunities. By identifying companies in fast growing, innovative industries where their structural advantages can be sustained and enhanced is rich potential for compounding earnings and ‘super-normal’ stock market returns. A significant fillip for active EM managers is the remit to invest opportunistically and selectively in smaller companies.

Small Caps are also highly inefficient reflecting paucity of quality analyst coverage which offers significant opportunity for alpha generation. This attribute is consistent across EM, EM Small Cap and World Small Cap as evidence by approximately three-quarters of active managers beating the index over time (gross of fees), compared to one-quarter in the case of US equity.

Small Caps, though, also come with increased risks. These include higher risk of business failure, limited access to capital, higher incidence of fraud, higher trading costs and higher single stock volatility. While these characteristics can be mitigated, the hurdle to picking ‘winners’ in the small cap universe is commensurately higher than for more established companies. A portfolio only invested in small caps is consequently much more vulnerable to market shocks – as small companies are far more likely to be impacted by negative changes in investor sentiment – and therefore display significantly increased volatility.

In short, a significant advantage for active EM managers over a World Small Cap manager is the ability to invest opportunistically and selectively in smaller companies without magnifying the volatility of their portfolio overall.

In summary, EM present an enticing proposition for global asset allocators, boasting a blend of growth potential and diversification advantages.

Firstly, investing in EM equities opens doors to opportunities in nations experiencing substantial macroeconomic shifts. These transformations can yield high returns as economies evolve and industries mature, offering investors a chance to capitalise on burgeoning markets and emerging sectors.

Secondly, the EM landscape encompasses not only established market leaders positioned to benefit from structural growth trends but also smaller enterprises operating in dynamic and innovative industries. This diversity within the EM universe provides investors with a spectrum of investment options, from established giants to agile startups, each with its own potential for growth and profitability.

A third point is the heterogeneous nature of emerging markets and its contribution to portfolio construction. By incorporating EM assets, investors can enhance the resilience and robustness of their portfolios, as these markets often exhibit low correlations with developed markets. This means that the performance of EM investments can move independently from traditional asset classes, reducing overall portfolio risk through diversification.

These appealing risk-return characteristics are distinctive to EMs and underscore their attractiveness as a component of a well-rounded investment strategy. However, it’s crucial to recognise that while EM offers unique benefits, World Small Cap investments should be evaluated through a separate lens in asset allocation decisions. Each asset class brings its own set of opportunities and challenges, and prudent allocation decisions should consider the distinctive attributes of each.

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Notes:
[1] IMF: https://www.imf.org/external/pubs/ft/fandd/2021/06/the-future-of-emerging-markets-duttagupta-and-pazarbasioglu.htm
[2] Ibid.
[3] https://www.worldeconomics.com/Regions/Emerging-Markets/