While their importance within investor portfolios has grown over the years, the debate over what actually constitutes an ‘emerging market’ continues to divide opinion.
Widely understood as a country ‘making progress towards becoming an advanced economy’, it depends on factors including liquidity and the presence of a regularity body for countries to qualify.
A more general way of looking at it is that it defines countries that are not as advanced as developed countries but have larger economies than those classified as ‘frontier’ markets.
The space has grown significantly in recent years. Indeed, in 1988 MSCI launched the Emerging Markets index which consisted of 10 countries representing less than 1 per cent of world market capitalisation.
Today, the index consists of 24 countries representing 10 per cent of world market capitalisation.
Table of countries in the MSCI Emerging Markets index
Source: MSCI
Rebecca McVittie, emerging markets investment director at Fidelity International said: “The definition of what constitutes an emerging market is relatively loose, and clearly captures a very broad range of countries in terms of the extent to which the economy has progressed.”
As such, some countries within the benchmark have already developed while others shows no signs of truly emerging, according to Hermes Investment Management’s Gary Greenberg.
“The concept of emerging markets isn’t really that valid anymore because only some countries really are developing and some countries are not,” the manager of the five FE Crown-rated Hermes Global Emerging Markets fund said.
“Some countries are not emerging because they have given up, some are frankly too corrupt – I won’t name names but some are – and for some countries the transition is just too difficult; especially if they don’t have an authoritarian, top-down government.
“I think in some cases to be able to escape from what I would call the commodity trap is just not going to happen.”
Conversely, there are countries in the index that have become more developed in recent years and are therefore ready to move on.
While Israel is now defined as a developed country and is an example of a country that has been promoted, others remain in the index.
“Poland is pretty much making it, I think. Czech Republic and Hungary: the same thing. There are policy errors that could happen but these countries are more or less in the tractor beam of development,” Greenberg said.
The most common countries among emerging market managers that should be moved into ‘developed’ status however are South Korea and Taiwan, which have both outperformed the wider MSCI Emerging Market index over the last decade.
Performance of indices over 10yrs
Source: FE Analytics
Fidelity’s McVittie noted: “The disparity is very evident when you compare South Korea’s GDP per capita with that of India: the former is approximately tenfold that of the latter.
“We often point to the attractions of emerging markets being based upon rising populations, favourable demographics, improving wages and the subsequent aspiration for a better standard of living will lead to rising consumer demand in emerging markets.
“These characteristics can be more prevalent in certain parts of the emerging world such as India and Africa, and less evident in countries like South Korea and Taiwan.”
Benchmarks such as the MSCI Emerging Markets index however are evolving, with the recent inclusion of the China ‘A’ shares an example of this, she added.
But adding to the confusion is the fact that different index providers have varying ways of categorising countries and therefore some can cross between developed and emerging indices.
Indeed, Mark Asquith, lead manager of the MI Somerset Emerging Markets Small Cap fund highlighted that South Korea forms part of the MSCI Emerging Markets index but is defined as developed country by rival FTSE.
He said that the definition of emerging markets should be kept as simple as possible for investors to understand.
“Insofar as emerging markets refer to economies in an earlier stage of economic development than mature Western markets, the term does not need to be redefined,” the manager noted.
While this definition may be overly simplistic, the hoops countries must jump through in the index extend to much more than this.
Other factors, such as openness to foreign capital, ownership and the size of the ‘free float’ as well as other reasons such as convertibility of the currency, must be taken into account when defining emerging markets.
Taking the example of South Korea above, Baillie Gifford Pacific manager Ewan Markson Brown noted that there are factors keeping it from moving into the developed market category.
“The emerging market index has changed so you have countries like Korea and Taiwan which are set to be developed in terms of wealth and technology and mostly legal structures but still have some of the old issues,” he said.
“In terms of corruption and investor transparency they are still emerging. So, you have got those two aspects – the institution is still emerging but the wealth isn’t.”
Meanwhile, countries such as Vietnam, which he said is a “true emerging market” is not in the MSCI Emerging Markets benchmark.
“Vietnam is one that is at the start of very fast growth and building up its institutions like the Asian tigers back in 1990s or China 15 years ago,” he explained.
There are also issues within countries, he noted, with the east coast of China likely to be fully developed during the next decade, while other parts of the country are unlikely to ever emerge, meaning in theory it would be best for the country to be split.
As such, Markson Brown said it is quite hard to find genuinely emerging markets despite the index classification.
However, most managers agree that while the classification is far from perfect, it is better that the index is broad and allows stockpickers to be flexible.
Fidelity’s McVittie added: “The index clearly serves an important purpose in that it allows investors to benchmark the performance of their managers and conduct risk analysis.
“Whilst the breadth of the emerging market universe may raise questions about the appropriateness of the collection of countries of which it is comprised, it is also important to keep in mind that a broader universe (for what remains a volatile asset class) give managers the flexibility to navigate away from certain parts of the market if the risks become more pronounced.”
As such, it would perhaps benefit investors to look for an active fund to navigate some of the countries in the index and hone in on those that are truly ‘emerging’.
“For us, the composition of the index itself is not something which keeps us awake at night,” she said.
“Portfolio construction seeks to capitalise on the very best stocks unearthed by our investment team, regardless of whether they are represented in the MSCI Emerging Markets index or not - as a consequence we cast the net much wider and are happy to avoid index names if the case for investment is lacking.”
Somerset’s Asquith added: “Ultimately our role at Somerset is to develop knowledge and expertise in certain country universes. It’s up to other people to name the dog.”