According to a recent Blackrock report, global emerging markets accounted for a 41% share of global GDP in 2022 (or 23% if you exclude China’s contribution) and contributed 43% to global economic growth (38% ex-China). Listed emerging market (EM) stocks, by comparison, have an equity market capitalization equivalent to 31% of the global stock market capitalization (16% ex-China). The share of EM in the MSCI ACWI, the predominant global equity index, is an even smaller 11% (8% ex-China). One might assume global allocations to EM equities would be comparable to their share of the ACWI, but EM currently comprises only 6% of investor portfolios.
(source: J.P. Morgan, “EM Money Trail”, 27 May 2022)
From a top-down strategic asset allocation perspective, EM appears well-positioned for inflows. The performance of EM was disappointing over the last decade as global investors favored US equity markets due to the surging popularity of the mega-cap technology stocks, a stronger US dollar, and relatively anemic fiscal stimulus in the EM world. With the prospect of slower growth ahead in most Western economies, we think it’s likely more investors will begin rebalancing towards EM for its superior growth characteristics and compressed valuations, potentially creating a protracted cycle of outperformance like we saw in the early 2000s.
If we look within the EM equity universe, the underrepresentation of frontier and smaller emerging markets compared to larger EM is even more dramatic than the underrepresentation of EM compared to developed markets, as described above. The aggregate GDP of FEM is approximately one-eighth that of EM, but stock market capitalization of FEM is a mere 1% that of EM.
Most global emerging markets managers have minimal or zero exposure to Frontier markets, our investment universe at Consilium, in part because EM indices favor the largest companies operating in the largest markets. China, for example, accounts for 33% of the MSCI Emerging Markets Index. The next four largest constituents represent another 44%.
From our perspective, the MSCI index methodology is flawed, as a company operating in a smaller market will typically have a smaller share in the index than a similar sized company in a larger market. With investors showing a strong preference for passive EM strategies, index providers are effectively determining how capital is allocated and perpetuating the trend of larger countries commanding a greater share of the index.
Outside of China, Taiwan, South Korea, India, and Brazil, there now exists a long tail of frontier and smaller emerging countries, each with its own nuanced story, that few managers are paying attention to. Many of these smaller markets are structurally attractive and possess competitive advantages, including young populations, critical natural resources, and low labor costs. When looked at as a group, these markets make up a meaningful share of global economic activity. As a result, Frontier has become fertile ground for active management.
Beyond the growing influence of indices, new regulations and the preponderance of large (>$5bn) EM managers have also deterred new investments in Frontier and smaller Emerging Markets. On the regulatory front, the E.U.’s MiFID II directive in 2018 declared that investment managers can no longer pay for research with “soft dollars,” which has had a significant impact on the supply and demand for EM equity research. To put it simply, large managers are less willing to cut checks for research on smaller EM markets where they can’t achieve economies of scale. This has further diminished their interest in investing in Frontier markets. As such, most GEM funds have virtually zero exposure to stocks with market caps below $1 billion or stocks that trade less than $1 million per day. This lack of attention has created valuation anomalies amongst smaller and less liquid stocks that lie outside the benchmark indices.
Frontier markets have long been the forgotten younger sibling in the investment universe, considered too underdeveloped and high-risk compared to the small basket of EM countries that constitute the lion’s share of EM allocations. This common misconception ignores FEM’s increasing and substantial contribution to population growth and economic activity, and the diversification benefits exposure to FEM can provide. Frontier markets have fewer links, both financial and geographic, to the developed world than their older EM siblings, and their idiosyncratic risks make them relatively less correlated to global markets. In 2021, for example, the MSCI Frontier Markets Index returned 20% for the year, while the MSCI Emerging Markets Index finished the year down 2% (both in USD). Relationships between Frontier, Emerging, and Developed Markets are far from static, and investors have been slow to recognize the abundance of under-the-radar opportunities that can be exploited in Frontier markets with skilled active management.