The recent retirement of Franklin Templeton’s emerging markets pioneer, Dr Mark Mobius, after 30 years with the firm, allows us to take stock of the remarkable growth of emerging market equities.
Going back to the late 1980s, there were only 10 funds in what is now the broad-based Thomson Reuters Lipper Global Emerging Market (EM) equity funds classification.
Today, there are some 1,200 funds in this classification and in 2017 alone, we saw more than 70 fund launches.
The extent to which the broad EM church in equities has widened is reflected also by the growth in country and regional classifications: Asia, Europe, and Latin America all have their own separate EM classifications.
Furthermore, there are 26 separate country fund classifications for countries from Morocco to Thailand, containing funds that could potentially contain a high proportion of EM shares.
In 2003, global EM equities funds contained around $115bn (£81.5bn) assets under management (AUM). Today, that total is just over $1trn, which represents an average annual AUM growth rate of some 25 per cent a year.
The proportion of traditional EM sectors such as energy and materials stocks have decreased materially.However, this has been anything but a neat compounding. In 2008 EM equity AUM contracted by 60 per cent, and more recently, with the tapering of quantitative easing in 2015, some 20 per cent.
For the 30 years ended December 31, 2017, EM equity compounded at 8.8 per cent a year (in US dollars) in contrast to global equity ex-US (6.5 per cent a year), but it still falls short of global equity US (9.1 per cent a year).
This was largely due to the magnitude of the global financial crisis drawdown, which affected EM equities over US equities by a magnitude of 2x.
The evolution in EM equities isn't just reflected in regional development and its infiltration into investor consciousness.
The composition of EM markets has shifted dramatically over the last ten years. The proportion of traditional EM sectors such as energy and materials stocks have decreased materially with a commensurate increase in technology and consumer exposure.
However, liquidity and volatility are key risks that, despite structural changes, remain. Gary Greenberg, manager of the US$3.4bn (£2.4bn) Hermes Emerging Market Equities Fund, points out that of the 30,000 EM stocks he considers his investible universe, there are fewer than 3,000 of sufficient liquidity to include in a modest-sized EM equities portfolio.
Compounding this issue further is the effect of passive vehicle concentration.
Approximately 33 per cent of fund assets (at the end of 2017) in the Lipper Global EM Equities classification are held in passive vehicles. By comparison, the equivalent figure for all funds registered for sale in Europe is 18 per cent.
Any late-cycle rotation out of passive vehicles into active funds could certainly affect EM markets disproportionately.
To illustrate this ownership concentration, the fund shareholder register for Tencent (the largest holding in the iShares MSCI Emerging Market ETF) reveals that of the ten largest fund shareholders for this stock, eight are passive or low tracking-error vehicles.
Despite the possible headwinds of increasing interest rates and potential appreciation of the U.S. dollar, the EM story remains compelling for many investors.
The contribution of EM countries to global GDP growth is material, and market valuations are relatively attractive.
One thing that hasn’t changed during Dr Mobius’s career, despite our increasing affection for EM and the structural changes, is the region’s volatility premium over other shares.
The average of the five-year volatility in EM equities since 1987 (rolling quarterly in USD) is 46 per cent higher than that of US equities and 32 per cent higher than that of global equities (ex-US).
Jake Moeller is head of UK and Ireland research for Lipper
