The optimism for exposure to emerging markets stocks is not as clear as frequently highlighted by the marketing materials of asset managers. Sure, perhaps some of these markets have higher economic growth rates than Europe or the US but there are also multiple concerns.
The MSCI Emerging Market index notes at the same level as in 2007, despite all the growth of emerging economies over the last 16 years. The index’s largest constituent country with a 32% weight is China, where lately the political regime has been anything but investor friendly. Worse, the medium to long-term outlook for its economy is not particularly rosy given record levels of debt, and a population that is expected to shrink by 400 million people until 2100.
We could further emphasise the high correlation of emerging market stocks and US high yield bonds, which implies limited diversification benefits, or that emerging market stocks mostly outperform when the US dollar is becoming cheaper, and therefore represent a currency bet, but this would be just nit-picking.
Let us assume an investor still wants exposure to emerging market equities, should he go for mutual funds or ETFs? Buy a global emerging markets index or multiple country indices? Select a smart beta or plain-vanilla product?
Although these asset allocation questions can be quite challenging, we will attempt to answer some of these using factor exposure analysis in this article.
Divergence across regions
We define our universe of possible investment opportunities as emerging market mutual funds and ETFs that have at least five years of track record and are available to US investors, which results in approximately 240 funds that manage almost $400bn assets. These can be differentiated by geographies, which includes global, regions and countries, and by investment styles.
First, we run a factor exposure analysis on four regions using monthly returns for emerging market factors from the Kenneth R. French data library and a five-year lookback. We observe that the factor betas were highly divergent. For example, Latin America and Africa had positive exposure to the value factor and stocks were cheaper than elsewhere in emerging markets while emerging Europe and Asia feature negative exposure. Every region offers a different multi-factor exposure combination.
Divergence within regions
However, the factor exposures are not only divergent across regions but also within them.
For example, the factor betas for emerging market funds in Asia are all over the place. China and Thailand have negative exposure to the momentum factor, i.e. stocks have been underperforming, compared to positive betas for India, Indonesia and Pakistan. None of the five factors used in this analysis shows the same direction for all five countries, which simply highlights structural differences of their economies and capital markets.
Smart beta versus mutual funds
Factor investing had a comeback in 2022 as most factors generated positive returns and some investors might be intrigued to pursue factor investing in emerging markets. Intuitively, it could even be more attractive than in developed markets given less sophisticated investors.
There are about 40 funds that provide exposure to single and multiple factors for global emerging market funds, which manage slightly more than $30bn assets. Some of these are ETFs, which explains why the median management fee is 0.89%, compared to 0.99% for general emerging market funds.
However, if we compare the ones that provide exposure to multiple factors, then the median betas to the five factors are not significantly higher than for plain-vanilla emerging market funds.
There is minor positive exposure to the profitability and investment factors, but essentially none to the value, size and momentum factors, which investors would have likely expected.
To be fair to fund management companies, the factor exposures depend on the product and some offer meaningful exposures. For example, the Ashmore Emerging Markets Small-Cap Equity fund invests in expensive and unprofitable small caps, which is debatable in terms of investment strategy, but at least offers something different than the MSCI EM Index.
In contrast, the FlexShares Morningstar EM Factors Tilt Index fund, which is significantly cheaper at 0.59% per annum versus 1.52% for the mutual fund, has factor tilts that are insignificant and make this fund essentially an index hugger.
Further thoughts
What have we learned from this analysis? It seems that emerging markets are complex and offer different factor exposures across as well as within regions. Mutual funds are not necessarily worse than ETFs, albeit more expensive on average.
Most investors will invest in emerging markets based on thematic views but this should be complemented with a quantitative assessment. As usual, know your factors. Nicolas Rabener is founder and CEO of Finominal
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To read the full magazine, click here.
