In 1981, an enterprising economist at the World Bank named Antione Agtmael was trying to win backing for the idea of a fund investing in developing economies. He was struggling with the name, and he knew this mattered. He was stuck on “third world equity fund”, but his colleagues weren’t sure. The name “Emerging Markets” was put forward and the rest, as they say, is history. This name has stuck like little else in the history of finance, and entire companies are now organised around this idea.
Words have a powerful influence on the way we frame concepts and think about things, often unconsciously. But, forty years later is this way of looking at the world outdated? I think it absolutely is. We are in desperate need of a new paradigm. Why?
- Developed / Emerging is a false dichotomy, the wrong way to look at the world. As the brilliant Hans Rosling carefully laid out in the epic book Factfulness, we intuitively cling to the idea of a them/us delineation in the world but this has not been true in practice looking at real data since at least the 1960’s. On any measure of development you will not manage to split the countries of the world into two neat groups. Perhaps in the early 1980’s, one could be forgiven for still thinking this way. In 2021, not so much. Rosling in fact proposed four tiers of development as better fitting the data. But the snag is that as everyone reading this blog is likely to be living in tier 4, we can at most only appreciate the lives of those one tier below: ie to tier 3. Hence we find it hard to conceptualise the other tiers that do exist. We lump everything else into one bracket, implicitly assuming that there is no difference between Iran and Afghanistan, India or Mozambique when there are of course vast differences.
- Emerging countries don’t actually emerge. The word emerging is loaded to say the least. There is dynamism and the promise of progress embedded within it. These places are in motion, transitioning – but to where? While those countries labelled as Emerging markets certainly have grown, and vastly increased income and wealth for their populations, moves up to the “developed” category have been elusive. So-called “convergence” toward developed markets has just not happened, partly because developed economies have continued to grow (research here from Schroders). A very small number have been formally upgraded to Developed Market status. Portugal in 1997, Israel in 2010, Greece in 2002 (only to fall back into Emerging a decade later). This signals important progress in these economies for sure, but the relatively lack of movement between emerging and developed markets starts to undermine the whole concept.
- Many so-called emerging economies show many signs of being more developed than … “developed”. When you actually look at the countries that form the bulk of Emerging market indices and portfolios, these aren’t in fact the countries at the early stage of development that you might imagine, instead they are pretty much all countries sitting on the third of Rosling’s four tiers: China, South Korea, Brazil, Malaysia, Russia etc. Consider the gleaming skyscrapers of Kuala-Lumpur, Mumbai, Sao Paolo or Qatar, the shiny infrastructure and transport systems of Shenzen or the high-tech chip foundries of Taiwan or South Korea. The proverbial alien coming from outer space might struggle to understand the difference in classifcation of these places compared to say a Detroit, Darlington or Scunthorpe– and I don’t mean for a second to be disparaging about those three places, quite the opposite, recent politics has highlighted the yawning gulf in investment and development among different areas in both the UK and US, and the DM/EM view of the world feeds a binary narrative that papers over the vast inequities within so-called developed economies. Most large countries these days could be thought of as consisting of sub-regions that contain both developed, and emerging economies. Countries that might be legitimately described as “developing”, on Rosling’s first or second levels are bracketed off into the truly marginal “Frontier markets”, with all the colonial connotations that wording brings.
As just one example, this definition from Investopedia, which is by no means unique, is clearly rubbish:
Critically, an emerging market economy is transitioning from a low income, less developed, often pre-industrial economy towards a modern, industrial economy with a higher standard of living.
Pre-industrial!! I suggest whoever wrote those words here pay a visit to Shenzen, KL or Sao Paolo. Or investigate the income per capita data for Qatar (3rd in the world) or South Korea (above the UK according to latest data) But these tropes are not challenged anywhere near as often as they should be. Some will argue that “emerging markets” are not the same as “emerging economies”, this might be true, but strikes me as a semantic run-around that just undermines the use of that terminology.
From an investment perspective though my real beef with the DM/EM dichotomy is that it serves investors badly and doesn’t lead to the best portfolios. It’s like using a 60-year old map of the world to try and navigate. In a world of low future returns it is becoming increasingly clear that investors need a new paradigm in order to set their portfolios up in today’s world and earn decent levels of return. Asset portfolios today are global, and the DM/EM approach to allocating manages to simultaneously make global asset portfolios underweight to three key groups of assets
- For the more developed of those countries currently labelled as “EM”, like China or South Korea, these end up underweighted by being hived off into the “satellite” allocation to Emerging Markets, which typically might just be 10-20% of an investor’s assets under the belief that these are inherently riskier. Remember we are talking some of the largest economies in the world here
- For the smaller countries in today’s emerging markets definition that have worked hard to improve their ease of doing business and openness to external investment these are crowded in portfolios out by the presence of the whoppers like China
- For the countries actually developing these are pushed out into Frontier markets, which rarely gets a look from institutional investors.
Some argue that investors get exposure to growth in “emerging markets” through companies listed in developed markets, but this dynamic is at least as true the other way round: for example two out of three of the world’s most high-tech chip “fabs”, which will supply more than 70% of the billions of devices built over coming decades are in “emerging markets”. These could well be some of the most important companies of the future, investors ought to ensure these feature sufficiently in portfolios.
The wildly successful Emerging Markets label is also hugely damaging today in my view and really holds back investors from seeing the world the right way. The common trope to be found in CFA, CFP textbooks the world over is that Emerging Markets assets are much riskier than their developed market equivalents and are to be treated with extreme caution, and held in only small allocations. The extent to which this damaging definition becomes internalised across the industry is really quite startling. But again, my real beef is how it damages our portfolios.
With c60% of all bonds globally yielding less than 1% per annum are Chinese (c3% p.a. yields), Indian or Brazilian (5% yields) government bonds really that risky when viewed long-term relative to inflation? How about the bonds of those “emerging” countries ranked by the Economist as having the highest levels of financial strength such as Botswana or Peru? Perhaps it might help our decision making to stop lumping those assets into the same broad category (“EM debt”) as bonds issued by Yemen or Iraq and acting like (consciously or not) that they are all the same.
Bonds is obviously an area where investors could be well served by looking at things differently, but equally, infrastructure is another example. Good infrastructure projects in investor-friendly countries and with good ease-of-doing-business ratings like say, Georgia (one place above the UK in ease of doing business), Malaysia (2 places above Australia) or the UAE (above Germany) ought to be viewed differently than the more risky propositions in countries that genuinely do carry big political risks. Again, lumping everything together really clouds our decsion making here.
Approaching its 40th birthday the concept of “Emerging Markets” has served its purpose but hasn’t aged all that well. But what should replace it? The answer isn’t easy, I don’t dispute that investors do need buckets to group individual markets as it is just too much to expect every investor to allocate between c200 global markets individually, but I don’t have a perfect answer for what a better system looks like. The classification is so deeply embedded in how the investment industry operates there are not many other paradigms to choose from right now with investible products.
One idea that I have seen proposed is to carve out a separate allocation to China A-shares alongside traditional DM and EM portfolios. I’ve nothing against this approach, but it seems like only a sticking plaster on the broader issues described in this piece.
Building on classifications that already exist perhaps the G20 would be more relevant to today’s world as a replacement for “developed” markets (and that would effectively bracket most of today’s “Emerging Markets” like China, Brazil and Russia alongside developed markets). A data-driven framework could be explored that better matches Rosling’s 4 levels.
Another option would be to abandon classifications and just let market-capitalizations sort it out for us, which would get us to something similar to MSCI’s ACWI index weights or the FTSE All World. One technical issue here is the index provider’s view of the practical investibility of equity in different markets, China A shares being the prime example where some have argued the index providers have been slow to react to opening up.
Finally, another alternative would be to look at equity allocations regionally, including developed markets. That way Asia could be separated from Latin America and Africa. That feels like a slightly backward step though – it’s where investors were a decade or more ago and the trend has been more globally focused mandates.
Given the success and power of the brand Emerging Markets and the way it has shaped our industry I’m not optimistic that things will change anytime soon. But given it’s basically grounded in a view of the world from the 1960’s, now more than half a century out of date I would like to think we could start to change it sometime before 2060, is that too much to ask?