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When Emerging Markets Grow Up

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Investors in emerging markets are typically attracted to the return potential in fast-growing countries. But do all emerging countries fit the bill? South Korea and Taiwan warrant special attention.

It’s been a difficult week for emerging-market (EM) equities, which have fallen sharply amid concerns about the potential impact of US policies on trade and currencies under Donald Trump’s incoming administration. Still, EM stocks have been solid performers in the year to date and many investors have been considering increasing exposure to the developing world. Exchange-traded funds that track an EM index are popular. But we believe that benchmarks are not the best way to position a portfolio in the developing world—in particular when it comes to country exposure.

Big Weightings for Mature Tigers

Two Asian tigers are a case in point. South Korea makes up 14.8% of the MSCI Emerging Markets Index, while Taiwan accounts for another 12.2%. So investors who stick with this index will be putting about 27% of their investment in these two countries by default.

But should South Korea and Taiwan even be considered emerging markets? Three decades ago, the answer would be a resounding yes. Between 1986 and 1995, GDP growth averaged 9.5% in South Korea and 8.4% in Taiwan (Display)—a healthy “emerging” pace by any definition. But since 2006, their growth rates have slowed to an annualized 3.5%—much closer to what you’d expect in more mature markets.

The comparison is even more revealing on a per capita basis. For South Korea, GDP per capita (at purchasing power parity) is US$37,699—99% of the European Union average—while for Taiwan, it’s 25% higher than the EU average is (Display above, right). In fact, South Korea’s GDP per capita is slightly higher than Italy’s is, while Taiwan’s is slightly higher than is that of Germany.

Low Exposure to Fast-Growing Countries

In contrast, the GDP per capita of India and the Philippines is about a fifth of the EU average. Both have grown much faster than developed countries over the past two decades. And their growth rates have accelerated over the past 10 years to 7.5% for India and 5.4% for the Philippines. Yet Indian stocks make up only 8.3% of the MSCI EM benchmark, while Philippine stocks account for only 1.3%.

So why do more mature countries remain in the MSCI EM benchmark today? It mostly has to do with the rules of the index provider. For example, MSCI uses corporate governance and market liquidity measures to determine what countries qualify as emerging markets. It doesn’t consider socioeconomic metrics, like per capita GDP, or access to the Internet, healthcare and financial services. Based on MSCI’s guidelines, South Korea and Taiwan don’t score high enough to rank as a developed market. As a result, investors who track an index end up with heavy exposure to countries that have slower growth rates.

Academic studies have shown that when developing countries are in catch-up mode, they tend to grow quite rapidly. But when these countries mature, growth tends to slow. That’s because after the catch-up stage, they need to reform their political and economic systems to continue growing rapidly. And many countries often find it difficult to make these types of fundamental changes.

Stockpicking Determines Country Positions

To be sure, this doesn’t mean that EM investors shouldn’t buy stocks in South Korea or Taiwan. But we believe that stock-picking decisions should be based on company-specific analysis. Individual stock opportunities should determine country positions in a portfolio—not the other way around. So depending on an investing philosophy, some EM equity portfolio managers might find enough attractive opportunities in mature emerging markets like South Korea to warrant having a significant country weight there.

Of course, a portfolio manager must research how the economic environment of a country affects a company’s business. And understanding the growth dynamics of countries and industries can help guide investors to opportunities. For example, since South Korea and Taiwan are relatively mature, smartphone and Internet penetration is relatively high (Display). That means investors might find better domestic growth opportunities in countries like India, Brazil or the Philippines, where penetration is much lower. Similar trends can be seen for mortgage penetration and car ownership.

It’s important to be aware of these trends when choosing an EM portfolio. By understanding the flaws of a benchmark, investors can avoid being automatically positioned with country weights that might be a burden on performance. In our view, investing in companies that truly benefit from the higher growth rates in the developing world is the best way to capture strong return potential in a sustained recovery of emerging markets.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

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