The rationale for holding emerging market equities has always been about strong growth. Over the long haul, however, investors with this mindset have been sorely disappointed. While emerging market economies have grown at a blistering pace, their equity indices have lagged. In fact, academics and practitioners alike have found GDP growth and stock market index returns to be frustratingly uncorrelated. Since ETFs are essentially tradable indices, a sensible question would be what ETFs are best positioned to capitalise on future emerging market growth trends. To answer, we need to revisit the central thesis for emerging market investing.
Focus on Demographics
Today, the emerging markets investment story might be better framed in terms of demographics. In developed economies--excluding the US--working-age populations are shrinking. By the mid-2020s, the eurozone's population will likely be in irreversible decline, and by 2050, a third of the eurozone's population will be over the age of 65. In contrast, emerging markets now find themselves in an enviable demographic sweet spot where population trends favour economic growth. In the ASEAN economies in south-east Asia, for instance, over 30% of the population is under the age of 20 with similar, though less extreme trends evident in the BRICs.
The emerging market youth bulge, measured in terms of both relative and absolute size, implies future economic growth, but of a particular kind: growth in domestic consumption. In the past twenty years, emerging market GDP growth has been fueled simultaneously by infrastructural investment and the adoption of an export-oriented growth model. Increasing productive capacity helped exports grow, which resulted in more hard currency. This helped expand productive capacity further and thus expand exports. This virtuous circle has expedited emerging market industrialisation and elevated living standards.
However, as emerging market economies begin to catch-up to developed nations, the historical export-led growth model will likely be replaced by consumption-led growth. Today, with a burgeoning middle class on the horizon in most of these economies, discretionary income per capita is poised to rise. As a result, domestically-oriented firms are best positioned to capitalise on people’s increasing purchasing power. Equity sectors that are likely best positioned to capitalise on this trend include consumer discretionary, consumer staples, healthcare, financials, and industrials.
Examining these particular sectors using Fama/French factors reveals these are not simply promising future investment ideas that have yet to materialise. Since 1995, after controlling for market risk, these domestically-focused sectors have historically exhibited robust return premiums over other export-oriented sectors like energy, basic materials, IT, and utilities. In all cases, the domestically-oriented sectors' outperformance can be attributed to various combinations of the size, value, and momentum premiums not present in the more export- and investment-oriented sectors. By implication, therefore, true investment “alpha” could have been gained by investing in domestically-oriented emerging market equity sectors.
Unfortunately, due to these firms' relatively small size, most pure market-capitalisation emerging market indices underweight domestically-oriented sectors relative to their future contribution to GDP growth. Not surprisingly, therefore, most emerging market equity ETFs underweight these sectors as well. Trying to find a large, liquid ETF that concentrates on our sectors of choice is no small challenge.
ETFs to Access Key Sectors in Emerging Markets
Currently, db X-trackers is the only provider that offers a full-range of emerging equity sector ETFs in Europe. However, the majority of these ETFs have less than EUR 4 million in assets under management and turnover only EUR 15,000 per day on average. While potential investors should be mindful of their lack of liquidity, these ETFs could be used to slice and dice an emerging market allocation into the most potent Fama/French factor combination possible.
Meanwhile, the iShares MSCI Emerging Markets Small Cap ETF (IEMS) on the London Stock Exchange is another option worth considering. It’s a larger fund with greater daily trading volume compared to the above mentioned ETFs. It tracks smaller-cap companies and focuses on those sectors that seem to be best suited to harness future trends in emerging market growth. The iShares product has a large allocation to consumer discretionary stocks, industrials and financials, while IT, utilities, and telecom represent only 20% of the index’s total value combined. Moreover, roughly half of the portfolio is invested in some of the most demographically-advantaged economies, like Brazil and the south-east Asian nations.
Demographic trends indicate that emerging market economies are poised to begin converting to consumption-led rather than export-led growth. In such a scenario, the most profitable, long-term investment opportunities likely lie in equity sectors that focus on serving the needs of the emerging market consumer. In fact, historically, domestically-focused sectors have exhibited robust return premiums above and beyond export-oriented equity sectors. Though the opportunity set for this specific thesis is currently small and somewhat illiquid, ETFs are nonetheless excellent investment vehicles to exploit these types of niche sectors and ideas.
