Emerging markets have more growth
Arash NasriSenior Vice President,Global Assets
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Originally featured in Investment Week
Market capitalisation-weighted investing may allow you to collect yesterday’s blooms, but investors need a more nuanced approach if they’re to seize opportunities that will blossom tomorrow.
I bought a bunch of flowers last week. Ever the romantic, when selecting a bunch, I wanted to get something beautiful – yes – but I also wanted to get my money’s worth. I wanted a colourful bunch that would be in flower for as long as possible.
This might seem like a sensible approach when it comes to something simple like buying a bunch of flowers, but it’s rarely adopted in more complex transactions, like investing.
Market capitalisation-weighted investing is a widely popular investment strategy. It involves buying stocks based on their size – the idea being that larger companies, with a higher market capitalisation, represent a greater share of the market and, therefore, a safer investment. Typically, it also means that larger allocations are made to generally more liquid assets.
Following this approach, a UK investor, for example, may choose to buy a relatively large holding of AstraZeneca stock and only a small holding of Taylor Wimpey. This market capitalisation-weighted investing tends to overweight to companies that have already grown, while underweighting those that are yet to bloom, which could lead to suboptimal returns over the long term.
This same approach is often applied by investors and asset allocators to determine geographic exposure, with greater allocations made to larger stock markets (e.g. the US) and smaller allocations made to less-dominant markets (e.g. Japan or select emerging economies). This method of investing by size is the basis on which some of the more simplistic passive fund management strategies are built.
The downside of this simple approach is that you find yourself allocating more to the winners of yesterday and less to the potential winners of tomorrow. Buying Apple Inc today will likely not be as good an investment as having bought Apple Inc when it was a much smaller business 15 years ago. The same can be said for allocating capital to large, developed markets versus smaller markets that are in their growth phase. Essentially, you’re buying a flower that’s already in full bloom (and indeed potentially beginning to wilt), instead of a flower that’s yet to blossom.
Over long time horizons, allocating to areas of the investment landscape that are currently growing is likely to deliver enhanced returns compared to investing in those that have historically performed well. By way of example, it may surprise some readers to learn that Japan’s proportion of the global equity market in the late 1980’s was over 40%. It’s now circa 6%. Any investor who chose to be underweight Japan during that time would likely have been rewarded.
Identify fertile economic conditions One approach is to invest based on the size of underlying economies as well as how strongly each country’s economy is growing, which could be determined by their gross domestic product ('GDP'). Emerging markets generally have higher GDP growth numbers than their developed market counterparts, and investing in these large and faster-growing economies is likely to pay off in the long term.
China, for example, which is still largely considered an emerging market, has the second-largest economy in the world and has been growing at a rate of around 6-7% per year over the past decade. In contrast, many developed markets, such as Japan and Europe, have been experiencing low rates of growth, and, in some cases, even negative growth.
In addition to higher growth rates, these markets often have lower valuations than their developed market counterparts, as well as less-established financial systems and investment analyst coverage. These inefficiencies often result in meaningful opportunities to benefit from undervalued investments.
It's worth caveating that these less-developed regions are typically higher risk – they can be more volatile, may be subject to political and economic instability, and often exhibit increased sustainability risks. Therefore, any exposure to these higher-risk markets should be taken in a thoughtful and balanced manner, consistent with client risk appetite, overall portfolio risk budget and investment objectives.
Maintain a balanced approachAn approach that we often take as investment advisers is to seek a balance between the two strategies mentioned above. In other words, an actively-managed portfolio with a mixture of developed and emerging markets, tilted slightly in favour of the latter.
For example, we might recommend a portfolio of 80% developed markets and 20% emerging markets, compared to a typical global equity index portfolio of circa 92% developed markets and 8% emerging markets. Our proposed portfolio would offer diversification and risk management, whilst targeting those faster-growing markets, offering greater potential for long-term outperformance.
This is why I asked the florist for a bouquet containing both blooms for today and buds for tomorrow.