Why do Emerging Markets seldom emerge?

Investing in emerging market equity funds (“EM”) is a terrible proposition. For investors who have allocated $300 billion to this asset class, a review of their strategy is essential for four reasons.

First, a spurious correlation exists between EM GDP growth and EM stock market returns. Despite a 9-fold increase in EM GDP over the last three decades, the MSCI EM index has generated a return of only 4.6% annually. More glaringly, China’s GDP has grown 40-fold over the last three decades, but Chinese stock market returns have been negative. While a broader index of developed global economies has grown GDP much slower than EM, annualized stock market returns have been twice as high as EM and three times as high as EM cumulatively in absolute terms, as shown in the table below.

Why has this happened? For non-China EMs, corporate profit growth per share has barely grown 3% annually over extended periods, a reminder of the questionable relationship between GDP growth and corporate profit per share growth. In the case of China, the inference is different: the elevated starting earnings multiple of Chinese stocks in 1993 perfectly discounted robust earnings per share growth that would accrue over the subsequent 30 years. To cut to the chase, higher economic growth – one of the key reasons to buy EM funds - certainly does not translate into higher stock market returns if one takes a long-term view.

Second, waiting for an EM bull market to emerge is much like waiting patiently to witness a comet: it may ultimately occur, but you wouldn’t regret missing it if you did. As a reminder, EM stock market returns were negligible for 25 out of the last 30 years across two distinct periods (i.e., 1993-2003 and 2008-2023). The one notable EM bull market occurred within five years, from 2003 to 2007. China’s rapid growth during this period was rare and generational, hence the analogy with a comet: it does not happen very often, it does not last very long, and you wouldn’t regret missing it if you remained invested more broadly in global equities.

Third, EM is akin to a remedial class in school. To appreciate why, consider the following: the largest constituent countries in the index three decades ago were Malaysia, Mexico, Brazil, Thailand, Chile, and Argentina. These countries have regressed from a global stock market perspective. One company in Korea and Taiwan - Samsung Electronics and TSMC, respectively - single-handedly ensured these countries remained relevant.

Three decades on, does EM still resemble a remedial class in school? For starters, China’s share of the EM index has increased from 0% to 28% despite negative stock market returns over this period. This is purely due to the higher weights accorded to Chinese stocks, given greater accessibility to foreign investors. Given that Premier Xi is looking to upend the global economic and geopolitical world order when financial leverage in China is approaching 300%, one thing is clear: EM remains a remedial class, just with a different group of countries in them. More pertinently, the advent of “EM ex-China” funds is even more ludicrous: the weight of several other countries within EM will increase proportionately, keeping EM’s reputation as a remedial class intact. Remember that India, the best performing EM over the last three decades, after all the sweat and toil, has barely delivered a return not too different from the MSCI World Index.

Finally, if a country does graduate from the EM asset class – Korea being the most probable candidate at the time of writing – it will get upgraded to “developed” market status, leaving the remedial class of EM looking even weaker within the composition of countries that remain. This explains why EM is not fertile ground for investors seeking absolute returns.

Fourth, certain qualitative factors need to be contended with, such as the rule of law (i.e., Russia disappearing from the index overnight), attitudes towards capitalism (i.e., China closing entire industries with the stroke of a pen), and the penchant for money-printing which decimates investment returns via weaker currencies (i.e., Brazil, Argentina, and South Africa). Matters in investing have a way of going from the impossible to the inevitable without stopping at the probable. EM funds have demonstrated how destructive this can be to investment returns, given that even the greatest companies and management teams cannot escape certain country-specific risks that plague EM. The long and littered history of EM reminds us that what China is experiencing today - and what many other EMs have experienced in the past - is not an aberration but the norm: attaining a balance between free-market capitalism and democracy is frighteningly complex.

In conclusion, only a handful of large world-beating companies in EM are worth the investment. One would require many more investment ideas to comprise an entire fund. Investors seeking diversification should invest in global funds instead. With due respect to asset allocators who extol the virtues of EM, hope has never been a sound investment strategy. The last 30 years have proven why. The subsequent 30 years will prove much of the same. What if you don’t have a multi-decade approach to asset allocation? Well, in that case, you should really be questioning what you are doing in the stock market in the first place.