Emerging Markets; the Myth that Failed

Why has the emerging market myth been so puzzlingly persistent? Many investors and commentators continue to recommend exposure to emerging market equities using an outdated and discredited narrative, despite their abysmal performance since late 2010 in both absolute terms and relative to developed markets, led by the US.

The term ‘emerging market’ suggests a pathway to convergence with developed markets. Since the inception of the asset class in 1988, only Israel and Portugal have undergone sustainable transitions from the emerging to the developed category although Taiwan, Korea and Poland are developed economies and markets in all but name but remain in the MSCI EM index.

The reality is that emerging equity markets lack any common secular drivers, the only real unifying features having been the initial phase of liberalisation in the 1990’s and post crises reforms, the rapid growth of China’s economy from 2000 to 2010 and the relatively low level of valuations following the series of EM crises from 1997 to 2002.

The subsequent rejection of more market based economic models led by China, has had a very detrimental impact on productivity, economic growth and corporate performance and is the major, if largely unacknowledged factor behind EM equity underperformance since the end of the big post-GFC rally in 2010.

Over the past three years, Chinese onshore and offshore equities which were by far the biggest constituent of the EM equity indices, have entered a prolonged bear market due to a combination of slower growth, financial distress in key sectors and state intervention under the banner of ‘common prosperity’ to the detriment of some of the leading listed companies.

Nor is there much prospect of a swift recovery, as the underlying imbalances in the Chinese economy and corporate sector have become increasingly visible, whilst some investors question whether Chinese equities are even investible, given concerns over corporate governance and the deteriorating relationship with the US.

Russia, Hungary, Turkey, Poland and Brazil stand out after China as markets where significant shareholder value has been drained by corruption and/or arbitrary state intervention in the corporate sector. In Mexico and South Africa economic growth has been constrained by poor governance in big non-listed parastatal enterprises.

Most of the markets that have undergone a shift towards more state intervention have delivered negative returns in USD terms since the end of 2010 even with dividend income reinvested, with equities in Chile, the erstwhile poster child for neo-liberal reforms, having more than halved since the end of 2010, while Russian equities have effectively gone to zero from the perspective of a foreign investor.

The big exception to date has been India, where the equity market has only been beaten by Taiwan and the US among major markets, but where sovereign governance has been moving in a more authoritarian direction under Narendra Modi and the BJP. However, increasing restrictions on media freedom and growing evidence of cronyism in the corporate sector, are important warning signs for investors, despite some progress with economic reforms.

The shift towards more authoritarian and state-led governance regimes across many of the leading emerging markets has exacerbated trade and geopolitical tensions, culminating (so far) in the proxy conflict between Russia and the US and her allies leading to the financial sanctions, which have resulted in Russia’s exclusion from the investible indices.

Russian stocks appeared very cheap before the 2022 invasion of Ukraine, so EM equity funds were in aggregate overweight according to data from Copley Fund Research, but these holdings are now valued at zero, thereby exposing another important component of the EM myth, that investors should buy and hold cheap stocks and ignore political ‘noise’.

Whilst Russia is an extreme example so far, it is easy to envisage what might happen to the foreign holders of Chinese equities in the event of a conflict over Taiwan, indeed over the past four years, US politicians have begun to exert pressure on big US investment institutions to justify their activities in China.

The financial services industry has been instrumental in propagating the myth of emerging markets long past its sell by date. Investment management firms make higher margins on EM active equity management products, despite there being no more evidence of consistent outperformance by the mass of managers than in other market categories, as most big firms tend to be closet indexers whose real focus is on marketing the EM myth to gather assets.

The sell-side investment banks are also enthusiastic promoters of emerging markets, due to the very high fees from primary and secondary share issues, especially in China and from trading revenues on secondary markets.

The role of the big index providers especially MSCI, has also come under increasing scrutiny as the volume of passive and active money benchmarked against the MSCI EM has grown.

MSCI still classifies Poland, Taiwan and Korea as emerging markets despite their status as developed economies, ostensibly for reasons of market accessibility. Reclassification as developed markets would reduce the critical mass of the higher margin emerging equity asset class, not helpful at a time when many investors are choosing an EM benchmark which excludes the biggest market, namely China.

Moreover, both MSCI and the investment management industry will be reluctant to antagonise the authorities in Beijing, who would take a very dim view of any upgrade for Taiwan, given that there is no prospect of China becoming a developed market.

The decision to admit Chinese ‘A’ shares to the MSCI indices in 2018 has also proved controversial as the shift towards more authoritarian sovereign and corporate governance structures was already very clear. Over the past year, MSCI has removed over 200 Chinese companies from the MSCI Global Standard indices after a sharp drop in the value of both onshore and offshore listed Chinese equities, whilst increasing the number of Indian shares after the market’s dramatic rise.

Many commentators now believe that Indian equities have entered a bubble phase, begun by the displacement effect of EM dedicated funds effectively having to redeploy their Chinese holdings into India, with momentum driven domestic retail then joining the party.

The most widely followed emerging market indices have a much higher proportion of state-controlled enterprises than their developed market peers; these companies generally prioritise broader political, social and even geopolitical objectives over shareholder value, with the most egregious examples in Russia, China, Brazil and Poland.

A joint study by Copley Fund Advisors and Ecstrat (my former company) in 2016, found that active EM funds’ largest underweight position relative to the benchmark was not in an industrial sector or individual country but rather in state-controlled companies . Passive investors do not have this option and are forced to invest in companies which are known value destroyers, a good example being the major global pension funds positions in state-controlled Gazprom and Rosneft in Russia prior to the invasion of Ukraine in February 2022.

Going forward, investors’ interests would be best served by the abolition of the distinction between frontier, emerging and developed markets, so investors should focus on the governance and other idiosyncratic risks of individual countries irrespective of their classification.

The taxonomy of Governance Regimes I developed at Ecstrat , bridges the gap between frontier, emerging and developed markets as a tool for dynamic asset allocation between markets, by mapping the context and shifts in sovereign and corporate governance by country. Since its inception in 2017, this methodology has an excellent track record in helping predict equity market performance by country over the medium to long term.

If emerging market equities are to be retained as an asset class, the honest solution would be to relabel them as ‘less developed markets’, exclude all the developed economies that are currently in the main MSCI benchmark and combine the remaining markets, with those which are now classified as Frontier or stand alone. The revamped asset class would obviously be much smaller and less liquid than the existing opportunity set, but it would be much closer to the original spirit of EM equity investing.