The financial crisis and subsequent fiscal adjustments and deleveraging in developed markets has enhanced the case for emerging market investing, says global investment strategist and specialist in emerging markets at State Street Global Advisors, George Hoguet, but investors are not taking advantage of the complete opportunity set.
The case for investing in emerging markets is compelling. The difference in growth rates between emerging and developed markets remains large, and the percentage of the world economy that the emerging markets makes up is estimated to grow from 35 per cent now, to 50 per cent in 2035.
Emerging market equities remain the most obvious exposure for investors, with the asset class performing well above developed markets for the past 10 years.
Most investors realise the return edge of emerging market equities, but the average asset allocation is well below the benchmark weight, says Hoguet, who is SSgA’s managing director.
“A crisis in emerging markets is not a thing of the past. But, the case for investing in emerging markets, given the economic environment in developed markets, has been buttressed. Being market-weight in emerging markets is a reasonable proposition,” Hoguet says.
He argues getting to the market weight of 14 per cent in emerging market equities should be accommodated by a corresponding reduction in the home bias (which should have an allocation reflective of the MSCI All World).
In addition, he says, in the next 20 years it is estimated emerging market equities will go from 14 to 30 per cent of world capitalisation.
This also highlights the broader trend in that the full opportunity set is much wider than the emerging market equities exposure of most investors, and includes opportunities to invest in small caps and emerging debt.
“There are three reasons to invest in emerging markets: return enhancement, diversification, and broader opportunity set,” he says. “This is a reasonable place to spend your risk budget because it’s not efficient.”
In terms of how to manage that exposure, Hoguet says the most important decision is to get a beta exposure “in one form or another”.
“The second decision is to get broad diversification and include sub-categories like small caps and frontier markets, and then decide how to structure between active, passive and alternative beta.”
Hoguet says the past year has been the best ever in terms of emerging market flows – $96 billion according to EPFR Global – indicating the growing interest, but warns that emerging markets is still a speciality asset class.
“The investment universe is always changing, countries are added and subtracted all the time. Even though it has become more mainstream, it is still a speciality asset class.”
But regardless, Hoguet says, the distinction between emerging and developed markets is arbitrary, pointing to both Greece and Portugal which are both defined as developed markets but were emerging markets as recently as 10 years ago.
“From an investor standpoint what they own is more important than how it is classified,” he says. “The strategic asset allocation shock from the global financial crisis continues to be felt, and the emerging world has come out with an enhanced position.”
Hoguet also says emerging market countries have better balance sheets at sovereign and consumer level, and the fundamental situation of emerging markets has improved dramatically in the past 10 years.
“The domestic GDP to debt levels are all good, emerging markets also have sustainable fiscal policy flexibility, and their banking systems are not encumbered by non-performing assets.”
Hoguet concedes there is still a high degree of uncertainty characterising the investment environment, but says the house view at State Street is there will not be a double dip.
“But global recovery is two track: emerging growth is robust; and the US will have a sub-par recovery,” he says.