Per MSCI, emerging-markets stocks made up about 11.6% of the global stock market (using the MSCI All-Country World Index as a proxy) as of the end of September. Thirty years ago, these stocks represented less than 1% of the world’s investable equity market capitalization. These markets are dynamic by definition. They have changed dramatically in the past three decades, and the pace of change has only accelerated in recent years. Here, I’ll look at emerging-markets stocks’ long- and short-term performance, the most recent phase in their ongoing evolution, how their makeup may evolve in the future, and what this all might mean with respect to portfolio construction.
Back in the Saddle
The MSCI Emerging Markets Index was launched on 1 January 2001. From its inception through the end of September, the index’s annualized return amounted to 9.89%, versus 4.99% for its developed-markets counterpart, the MSCI World Index. Though these headline performance figures are compelling, they belie the gut-wrenching volatility that has characterized this span. During this period, the emerging-markets index’s standard deviation of monthly returns and maximum drawdown were 22.07% and 61.59%, respectively. The comparable figures for the MSCI World Index were 15.19% and 54.03%, respectively. Emerging markets’ path to greater absolute returns has been a winding one.
Recent years have been particularly taxing for investors in emerging-markets stocks. From the time that the emerging-markets index’s cumulative performance peaked relative to developed markets in October 2010 (see Exhibit 1) through the end of 2016, the MSCI Emerging Markets Index fell 1.1% on an annualized basis, while the MSCI World Index generated annualized gains of 8.74%. But after almost seven lean years, emerging-markets equities have re-emerged in 2017. For the year to date through September, the emerging-markets index increased 27.78%, while its developed-markets counterpart rose 16.01%. Digging into the drivers of the benchmark’s year-to-date performance yields some interesting insights into how its complexion has changed in recent years.
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Then and Now
Exhibits 2 and 3 decompose the portfolio of iShares MSCI Emerging Markets ETF (EEM, listed in the U.S.) into its constituent country and GICS sector exposures. It is readily apparent that the composition of this cohort has changed materially over the past few years. From the point of view of country membership, the most significant changes have been the decline in Brazilian stocks’ share of the portfolio (from a peak of 16.9% in November 2009 to just 7.2% as of end-August 2017) and the increase in Chinese stocks’ share (which has risen to 28.9% from 15.5% during this same span). In terms of sector composition, there’s been an even more significant shift in the index. In November 2009, energy and materials stocks represented a combined 29.8% of EEM’s portfolio. As of the end of August, this figure had declined to 14.1%. Back in 2009, technology names accounted for 15.3% of EEM’s portfolio; by the end of August 2017, that figure had increased to 26.9%.
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Of course, this evolution is only natural. The MSCI Emerging Markets Index is a broad, market-cap-weighted benchmark. As such, it will reflect the ebb and flow of firm-level fundamentals, investor sentiment, capital flows, and so on across these markets. Thus, the shift in the makeup of EEM’s portfolio represents the net result of all the above, as manifest in their relative performance. From November 2009 through August 2017, the MSCI China Index gained 6.30% on an annualized basis, while the MSCI Brazil Index declined by 4.15% annualized. These divergent paths speak to effects of the commodity boom and subsequent bust on Brazil’s stock market (and currency) and the emergence of a pair of tech giants— Tencent Holdings and Alibaba Group—in China.
This brings us to emerging markets’ 2017 reawakening. An attribution analysis of EEM’s year-to-date performance through the end of September reveals that the above-mentioned Chinese tech behemoths have combined to account for more than 5 percentage points of the fund’s gains. Rounding out the list of the fund’s top five contributors are Samsung, Taiwan Semiconductor, and Naspers—which have collectively added about 4 percentage points to EEM’s 2017 effort. The tech-led stock rally is not a U.S.-only phenomenon—emerging markets are participating, too. The transition from a portfolio dominated by basic materials and energy giants to one led by emerging titans of technology has marked the most recent evolution of emerging stock markets, but what might come next?
In part 2 of this article, we will take a look at what the future of the emerging markets might hold.
