The term “emerging markets” was coined by International Finance Corporation (IFC) officials, in 1981, to give these markets a more uplifting and optimistic name. Previously, those countries were referred to by different and sometime unflattering names such as the “poor countries”, “underdeveloped countries”, “less developed nations”, the south and so forth. Prior to that time economists were deeply involved in trying to solve the mystery of economic growth. Why were there poor countries? Why couldn’t countries grow and become rich? What was holding them back? Aid handouts to the poorer nations from the rich, particularly the U.S with its Agency of International Development (AID) wasn’t working and didn’t have the growth results that were expected.
When I was studying economics at MIT in the 1960s, economists were coming up with all kind of theories of what was wrong and how it could be solved. One economist said the key was steel. If a country built a steel plant then that would be the impetus for development. Another said a railroad was the key. Another said child rearing was the key, particularly in the first five years of life. There was a lot of talk about the “Protestant Ethic” and how Europe and the US developed based on it. But then the question of Japan’s development seemed to deny that explanation.
Finally, consensus began to focus on the importance of how resources were allocated and how a market economy, as opposed to a socialist or communist system of resources allocation, was the best way to allocate resources which could lead to development. Therefore, multilateral agencies, starting with the World Bank and International Finance Corporation, began to advise countries to switch their development models to market-oriented ones. This meant that stock and bond markets had to be developed and revived (since many countries had allowed these institutions to close). This opened the avenue for both domestic and international investors to introduce capital into those countries’ capital markets.
In search of above-average returns, investors ventured into countries which were at early stages of development expecting those countries to record rapid economic growth as a result of the adoption of market-oriented policies and greater globalisation. As such, early investors in emerging markets were able to invest in companies which trade at attractive valuations because they were typically under researched, undiscovered and had limited accessibility by the wider investment community at that time.
Over the last decades, emerging markets recorded faster growth rates than their developed counterparts as they became increasingly sophisticated and integrated into global markets. A growing middle-class population, with higher incomes and greater consumer demand, in major emerging markets such as China and India, has also supported economic growth. Further, this trend is expected to continue for the foreseeable future. Representing a very economically diverse group which accounts for nearly three quarters of the world’s land mass and four fifths of the world’s population, emerging markets recorded a combined average annual growth rate of 5.5% over the last 20 years (more than double the 2.1% growth by the developed markets). For 2016, emerging markets are forecasted to grow 4.1%, more than double the 1.9% expansion expected in developed markets.
When we launched our first emerging market fund in 1987, there were only a handful of markets we could invest in, but gradually over time, the amount of money pouring into emerging markets grew significantly. With the subsequent development of formal securities markets, equity legal structures and trading systems, investors increasingly began identifying international equity investing not only with foreign developed countries but also with the emerging markets of the world. Today, we can invest in about 70 markets and the investment opportunities continue to expand.
Emerging equity markets have also performed better than their developed counterparts from 1995 to 2015. Based on a US$1,000 annual dollar cost averaging investment, US$20,000 invested in emerging markets would have returned US$41,250 at the end of the 20-year investment period, higher than the US$39,418 in developed markets.
The 20-year annualised return for emerging markets was 3.7% versus 3.4% for developed markets. Advancement in investors’ attitude towards emerging markets investing supported the growth and expansion of the stock markets in these countries. Initially, investors had a more apprehensive attitude towards investing in regions outside of the typical developed international markets such as the US, the UK, Germany, Japan and so forth. This was because emerging markets offered different challenges to those that were present in developed markets. Those challenges were often also much more diverse than those encountered in traditional investment arenas. They included concerns such as a lack of proper regulation, paucity of information and transparency, political turmoil, social and economic instability, foreign investment restrictions and currency devaluation. While some of these risks still exist, they are not as prevalent as they were in the 1980s and 1990s. Moreover, investors have learnt that most of these risks can be properly assessed and managed, providing more than commensurate returns.
The growing interest in emerging markets over the last 20 years is evident by the substantial increase in the market capitalisation of emerging markets as a percentage of the world market capitalisation. The weighting of emerging markets has risen from 12% in 1995 to 34% in 2015. Emerging market companies have raised more than US$3.3tn in initial price offerings and follow-on issues in the 20-year period ending in 2015, clearly highlighting the significant investor confidence in these markets. Moreover, portfolio fund flows into emerging markets have totalled about US$160bn in the last 20 years, according to EPFR Global.
The evolution of international investing continued with investors increasing their interest in and coverage of emerging markets by venturing into frontier markets, which included markets in regions such as Africa (excluding South Africa), the Middle East, Balkans and Baltics. The willingness of governments to open their markets and investors’ desire for access to fast growing and developing markets led to the development of a newer asset class – frontier markets.
Typically smaller and less liquid than emerging markets, the frontier markets investment universe is sizable and has been generating significant investor interest. One of the most exciting aspects of emerging and frontier markets development has probably been the creation of new equity markets, particularly in those countries transforming themselves from communist/socialist economies to capitalist free-market economies. In Vietnam, for example, the requirement for privatisation of state owned enterprises generated an interest by the government to develop capital markets. Vietnam finally launched its first post-war stock exchange in July 2000 with just two listed stocks. Currently, there are more than 600 stocks traded on two stock exchanges, highlighting the rapid growth of the country’s equity markets. Frontier markets, which could grow into tomorrow’s emerging markets, have begun to look very interesting in the last few years. They are where many emerging markets were 15 or 20 years ago. Thus, frontier markets today can provide investors with a very attractive investment opportunity, comparable to emerging markets in the late 1980s. The growing investor interest in frontier markets subsequently led index providers MSCI and IFC/S&P to launch specialized indices for the asset class, warranting them greater attention and research. Frontier markets are going to develop into emerging markets and investors should not miss the opportunity to take advantage of their growth.
Lastly, we’ve noted that many investors underweight emerging markets. As mentioned above, emerging market equities represent over 30% of the world market capitalization, yet investors generally have a much lower weighting in this asset class in their portfolios. About one-third of investors surveyed in the Merrill Lynch Fund Manager’s Survey are underweight emerging markets equities. Thus, we strongly believe that a large number of investors are missing out on benefiting from investing in the fastest growing economies.