4 strategies for investing in emerging markets

Christopher Dhanraj |Nov 8, 2019

Chris explores ways to manage your EM allocation, an out of favor, but still appealing asset class.

Emerging markets were the darling of investors as recently as early 2019, but now find themselves once again as unloved as wearing white after Labor Day. The asset class has suffered under a barrage of tweets, tariffs and uncertainty: The MSCI Emerging Markets Index is down 19% from its January 2018 peak, while the S&P 500 is up 5% over the same period.1 Exchange traded fund (ETF) flows have followed suit, with nearly $10 billion redeemed from EM equity funds in August alone, putting YTD cumulative flows close to flat.2

But just because EM is down doesn’t mean it’s out. Indeed, signs of resiliency are appearing in the flows, which recently broke their losing street: During the week of September 16, $700 million flowed into EM equity ETFs, primarily in country specific funds tracking China.

Down but not out
Global country ETP flows, trailing 1 year as % of AUM

Down but not out

Source: BlackRock, Markit, as of September 5, 2019.

Still, it is important to consider maintaining some exposure to EMs, which offer access to growing parts of the globe with rising middle classes and potential diversification and growth. In addition, EM is still relatively inexpensive.3

Here are four suggestions for investing in emerging markets beyond the traditional regional implementation.

1. Consider minimum volatility strategies.

Investors concerned about volatility may want to consider minimum volatility funds, which potentially can smooth out the ups and downs of EM investing. Consider the example of the recent decline: The MSCI Emerging Market Minimum Volatility Index is down around 10% since January 2018, well outperforming the MSCI EM Index’s 19% drop.4

2. Tailor your EM portfolio around countries or regions.

The EM landscape is changing: Saudi Arabia, Argentina and China A shares have entered the index, but counterintuitively it is getting more concentrated despite the new entrants. In just five years China’s weight in the MSCI Emerging Markets Index has risen from ~20% to 33% currently and is expected to exceed ~40% at full inclusion of China A shares (source: MSCI, as of August 2019).

Investors are taking notice of China’s 33% weighting within EM benchmark.5 With rising China risk driven by U.S./China tensions and lowered earnings expectations, the MSCI China Index has fallen nearly a quarter from its peak, dragging the rest of the EM index down with it. It’s possible that as China’s weight grows within the index, we’ll see treatment of EM ex-China comparable to that of Developed ex-U.S. or Asia ex-Japan.

One potential solution? Consider carving out China as a standalone allocation through an emerging markets ex-China strategy. More generally, investors can consider adopting a country-focused approach in their international portfolios as I discussed in greater detail in February. Concentrated risk exposures, low correlations across EM, and high return dispersion suggested EMs are well suited for such an approach.

A changing EM landscape
China has grown as a % of the MSCI EM Index

A changing EM landscape

Sources: BlackRock and MSCI as of September 5, 2019. Allocations are subject to change. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

3. Consider a broad-based exposure, but manage political event risk.

Investors may want to consider a differentiated approach for tactical and strategic trading using broad EM exposures, making tactical trades around Federal Reserve meetings or geopolitical events. Where possible, consider currency hedged EM ETFs to play pure equity views, such as in Mexico.

4. Take a look at EM Debt as a potential complement to an EM equity portfolio.

EM debt looks attractive – with a current yield of 4.4%6 – and offers a complementary geographical exposure to the Asia heavy EM equity indexes. So far in 2019, more than thirty central banks have cut rates, with the Fed and the European Central Bank messaging that further accommodation might be needed.7 In a global rate cutting environment, investors may be able to benefit by looking to EM debt for a yield alternative.

Whether EMs come back in favor this week or next year, we believe most investors should consider some allocation over the long term to this important asset class. And ETFs can offer the flexibility to implement that allocation through a range of applications.

Christopher Dhanraj
Chris Dhanraj is the Head of the iShares Investment Strategy team.