RESEARCH INSIGHTS

THE FUTURE OF
EMERGING
MARKETS
30 Years On from the Launch of the
MSCI Emerging Markets Index

Dimitris Melas

April 2019

APRIL 2019
 THE FUTURE OF EMERGING MARKETS | APRIL 2019

CONTENTS Executive Summary ........................................................................3

The Evolution of Emerging Markets ..............................................4
Examining Allocations to Emerging Markets ...............................8
Sources of Risk and Return in Emerging Markets..................... 16
China and the Future of Emerging Markets ............................... 27
Conclusion ................................................................................... 30
References ................................................................................... 31

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

EXECUTIVE SUMMARY
For the past 30 years, emerging markets have provided return enhancement and risk
diversification opportunities for global equity investors. The ongoing liberalization of
the domestic Chinese capital market has the potential to transform the
characteristics of the equity segment and its role in global portfolios. Recently,
emerging markets have experienced volatile performance, driven by changes in
monetary policy, increasing political uncertainty and deteriorating conditions for
international trade. Are these factors temporary or could they have a long-lasting
impact? Will emerging markets remain a distinct equity segment and will they
continue to represent an essential portfolio allocation for international investors?
We can trace the genesis of emerging markets as a distinct equity segment to the
launch of the MSCI Emerging Markets Index in December 1987. At that time, the
index covered 10 countries, making up less than 1% of the global equity market, as
reflected in the MSCI All Country World Index (now known as ACWI). Emerging
markets have experienced dramatic growth and transformation over the subsequent
three decades. As of Jan. 31, 2019, the MSCI Emerging Markets Index comprised 24
countries, representing almost 12% of the MSCI ACWI Index.
The rationale for allocating to emerging markets rests on three pillars: Superior
economic growth has resulted in positive market returns historically, low correlation
within emerging markets and across asset classes has provided diversification
benefits, and relative scarcity of information has created opportunities for active
portfolio management. Long-term historical data confirms that emerging markets
have provided positive long-term risk-adjusted excess returns and enhanced portfolio
diversification. Their diversity has led to high cross-sectional return dispersion, both
at the country and at the security level, creating opportunities to add value through
active country allocation and stock selection. Omitting this equity segment would
have introduced a performance drag on global indexed strategies and reduced the
investment opportunity set of active strategies.
The opening of the domestic Chinese capital market and its integration into
international markets is likely to have a transformative effect on the emerging
markets equity segment. MSCI introduced domestic Chinese equities (A shares) into
the MSCI Emerging Markets Index in June 2018 at a reduced weight. Chinese
equities listed in mainland China and Hong Kong currently represent 30% of the index
but could grow to over 40% when A shares are included at full weight. The growing
size of China within emerging markets raises the prospect for investors of making
dedicated allocations to China. Whether investors make separate China allocations
or continue to seek opportunities across global emerging markets, the segment likely
will remain an essential element of the global equity universe in the future.

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

THE EVOLUTION OF EMERGING MARKETS

Historically, institutional investors focused on their domestic equity market. In the
late 1970s, several investors started to invest internationally across developed equity
markets, mainly North America, Western Europe and some developed countries such
as Japan and Australia in the Asia Pacific region. In the late 1980s, a few pioneering
investors ventured beyond developed equity markets and started to seek
opportunities in developing countries in Latin America and South East Asia. These
investors faced considerable obstacles across the entire investment process,
ranging from difficulties in obtaining information about listed companies to
operational challenges in opening investment accounts, trading, settling trades,
safeguarding securities and repatriating the proceeds of their investments. However,
for these pioneers, the attraction of emerging markets remained compelling despite
these challenges, as they anticipated that rapid economic development would
translate to high earnings growth and, combined with attractive valuations, would
lead to superior portfolio returns over time.
In response to the growing needs of these investors for information and tools to help
them conduct investment research and asset allocation in emerging markets and to
benchmark the performance of their portfolios, the MSCI Emerging Markets Index
was created in December 1987. At its inception, the index included 10 markets
(Argentina, Brazil, Chile, Mexico, Portugal, Greece, Jordan, Malaysia, the Philippines,
Thailand) and represented less than 1% of the global equity universe, as reflected in
the MSCI All Country World Index (since renamed “ACWI”).
An avalanche of political and economic events, including the adoption of market-
oriented policies in China, the collapse of the Soviet Union, the spread of democracy
in Eastern Europe and the fall of apartheid in South Africa, led to the rapid expansion
of the emerging-market universe throughout the 1990s. By 1992, the MSCI Emerging
Markets Index had grown to cover 13 markets and represent 5.3% of MSCI ACWI. By
1997 the index covered 28 markets and had a weight of 6.8% in MSCI ACWI.
The rapid globalization of portfolio investments and fast-moving international capital
flows combined with relatively weak institutional governance and flawed
macroeconomic policies led to the Asian financial crisis of 1997 and the Russian
debt default of 1998. These events hit emerging markets directly and were followed
by the burst of the technology, media and telecom (TMT) bubble and the global
recession and bear market of the early 2000s. As a result, emerging markets (using
the MSCI Emerging Markets Index as a proxy) underperformed developed markets in
the late 1990s and by 2002 only represented approximately 4% of the global equity
universe.

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

The equity segment recovered and attracted greater investor interest and allocations
throughout the 2000s, leading to the outperformance of emerging markets relative to
developed markets in the first decade of the 21st century. Market accessibility has
improved gradually but steadily throughout the last two decades, as domestic
regulators and stock exchanges enhanced the operational framework and market
infrastructure, leading to declining trading costs through time. In 2007, MSCI created
the MSCI Emerging Markets Small Cap Index and the MSCI Frontier Markets Index, to
serve investor needs for benchmarks reflecting the small-cap sub-segment in
emerging markets as well as countries that were beginning to develop their equity
market but had not yet reached sufficient levels of size, liquidity and accessibility to
be considered “emerging.”
In the last few years, the ongoing development and liberalization of the domestic
Chinese equity market has been the dominant change in the emerging-market
segment and led to the inclusion of A shares in the MSCI Emerging Markets Index in
June 2018 at a small fraction (5%) of their free float. MSCI has announced that it will
increase the percentage of A shares free float included in the index from 5% to 20%
by December 2019. Chinese equities currently make up 30% of emerging markets but
could rise to 40% should A shares be fully included at 100% of their free float, based
on market capitalizations as of Jan. 31, 2019.
Exhibit 1 chronicles the introduction of new equity markets into the MSCI Emerging
Markets Index and the MSCI Frontier Markets Index. Currently, the MSCI Emerging
Markets Index comprises 24 markets representing 12% of the MSCI ACWI Index.
Exhibit 2 plots the performance of developed and emerging markets in absolute
terms while Exhibit 3 shows the relative performance of emerging markets since the
inception of the MSCI Emerging Markets Index. 1

1The analysis and observations throughout this report are limited solely to the period of the relevant
historical data, back test or simulation. Past performance — whether actual, back tested or simulated — is
no indication or guarantee of future performance. None of the information or analysis herein is intended to
constitute investment advice or a recommendation to make (or refrain from making) any kind of investment
decision or asset allocation and should not be relied on as such.

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Exhibit 1: Additions to MSCI Emerging Markets and MSCI Frontier Markets Indexes
1988 1989 1992 1993 1995 1996 1997 2001
Argentina Indonesia South Korea Colombia Israel China Russia Egypt
Brazil Turkey India Poland Czech Rep. Portugal Morocco
Chile Pakistan South Africa Hungary
Greece Peru Taiwan
Jordan Sri Lanka
2
Malaysia Venezuela
Mexico
Philippines
Portugal
Thailand

2006 2007 2008 2009 2012 2016 2018 2019

Bulgaria1
3 4
Bahrain Lithuania Bangladesh Saudi Arabia WAEMU China A China A4
1
Kuwait Croatia Serbia Trin. & Tob. Argentina
Oman Estonia Saudi Arabia
Qatar Kazakhstan
UAE Kenya
Lebanon
Mauritius
Nigeria
Romania
Slovenia
Tunisia
1
Ukraine
Vietnam

Country Introduced as Emerging Market/Frontier Market

1
Trinidad and Tobago, Ukraine and Bulgaria were removed from the MSCI Frontier Markets Index in 2001, 2015
and 2016, respectively.
2
Venezuela was removed from the MSCI Emerging Markets Index in 2006.
3
Saudi Arabia was re-introduced into the MSCI Domestic Indices as standalone index in 2012 and into the MSCI
International indexes as standalone in 2015.
4
In March 2018 the MSCI China A index was launched, offered in CNH and CNY versions. In May 2018 Large Cap
China A shares were added to the MSCI China index, the MSCI Emerging Markets index and MSCI ACWI index at
5% of their FIF-adjusted market cap. The inclusion factor of China A will be raised to 20% in three steps in 2019.

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

Exhibit 2: Absolute Returns of EM and DM Indexes (Gross Total Return)

Exhibit 3: Performance of EM Relative to DM (Gross Total Return)

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

EXAMINING ALLOCATIONS TO EMERGING MARKETS

Investors making portfolio allocations to emerging markets typically look at two sets
of variables, namely, macroeconomic indicators and market indicators. In this
section, we will examine both sets of variables, investigate their historical
relationship with emerging market performance and evaluate how they may affect
the equity segment in the future.
With respect to macroeconomic variables, we analyze indicators relating to four
categories:
1. Sustainable economic growth
2. Monetary policy, price stability
3. Fiscal discipline, debt position
4. Trade, current account balance
We examine the historical evolution and future anticipated path of these four main
macroeconomic indicators (using IMF forecasts). We find that emerging markets
have provided superior economic growth historically but have also been subject to
considerable macroeconomic volatility. While the growth premium over developed
economies has moderated, it is expected to continue over the coming years,
supported by the broad adoption of policies that seek to promote fiscal discipline
and price stability.

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Exhibit 4: Real GDP Growth, Annual Percentage Change

Exhibit 4 plots the annual percentage change in real gross domestic product (GDP)
for emerging markets and developed markets. 2 This exhibit shows that emerging
markets historically experienced higher economic growth compared to developed
markets, and the International Monetary Fund (IMF) expects this pattern to continue
through 2023. Specifically, in the 1980s, we observed little difference between the
two groups. However, in the 1990s, as emerging markets started to develop rapidly,
and many began to adopt free market policies, they experienced higher economic
growth, although this was interrupted by the Asian financial crisis of 1997. Higher
growth resumed after 1998 and has persisted throughout the last two decades. This
growth gap in favor of emerging markets is expected to continue over the next five
years, according to IMF forecasts.
Exhibit 5 shows annual inflation rates for emerging and developed markets over the
last 40 years. Emerging markets experienced higher inflation in the 1980s, which
accelerated further in the early 1990s. However, as many emerging markets
reformed their monetary policies and introduced independent central banks with
price stability mandates, inflation declined in the late 1990s and has gradually
converged toward developed-market levels in the last 20 years. Forecasts from the

2
Exhibits 4-7 in this section show macroeconomic indicators using the IMF definitions of Advanced Economies, Emerging
Markets and Developing Economies and World. The precise country composition of these IMF groupings can be found at
https://www.imf.org/external/pubs/ft/weo/2019/01/weodata/groups.htm

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

IMF anticipate that emerging-market inflation will remain low over the coming five
years.
Exhibit 5: Inflation Rate, Annual Percentage Change

Exhibit 6 displays net public debt, as a percentage of GDP, for developed and
emerging economies. Debt levels in developed markets rose in the 1990s, remained
elevated in the early and mid-2000s, and increased further in the aftermath of the
global financial crisis of 2008. The IMF estimates that net public debt as a
percentage of GDP will stay close to 80% for developed economies over the next five
years. Emerging markets have followed a different path, with debt peaking in the
early 2000s and then declining gradually through the decade, following the adoption
of sound fiscal policies by many emerging economies. Debt levels have started to
pick up recently, but the IMF expects them to remain significantly lower than for
developed markets in the next five years.
Exhibit 7 describes the evolution of trade across developed and emerging
economies, as reflected in their current account balance, as a percentage of GDP.
Emerging markets established a sizable trade surplus in the 1990s, which expanded
in the 2000s, underpinned by increasing business globalization and foreign direct
investments into emerging markets that sought to benefit from lower labor costs and
other comparative advantages enjoyed by emerging economies. In the current
decade, as China and other emerging markets have started to shift gradually from
investment and exports to consumption, the trade surplus they previously enjoyed

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

with developed markets has been eliminated. However, the United States continues
to have a current account deficit, which the IMF expects to persist in the next five
years.

Exhibit 6: Net Public Debt, as a Percentage of GDP

Exhibit 7: Current Account Balance, as a Percentage of GDP

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

Having discussed the historical evolution and outlook of key macroeconomic

indicators, we now turn to leading indicators and market variables that investors
typically examine when making allocations to emerging markets. Specifically, we
focus on the following variables:
1. Business cycle: OECD Composite Leading Indicator (CLI)
2. Risk aversion: CBOE Implied Volatility Index (VIX)
3. Interest rates: US Treasury 10-Year Constant Maturity
4. The US Dollar: US Dollar Trade Weighted Index
Exhibit 8 shows the recent evolution of these variables, while Exhibit 9 summarizes
the long-term relationship between them and the outperformance of emerging
markets relative to developed markets. Emerging markets generally performed well
when business conditions were improving, when investor risk appetite was rising,
when interest rates were declining and when the U.S. dollar was weak relative to
other currencies. The analysis presented in Exhibit 9 confirms most of these
relationships. Specifically, we observe that, historically, emerging markets
outperformed when the CLI was rising, when the VIX was falling and when the USD
was weakening. On the other hand, we did not find a consistent relationship between
U.S. interest rates and emerging markets performance.
Exhibit 8: Recent Evolution of Key Leading Indicators Used by EM Investors

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Exhibit 9: Emerging Market Performance and Leading Indicators

Data from Dec. 31, 1998 to Jan. 31, 2019

We conclude this section with a discussion of emerging-market valuations and

market performance. We assess valuations using two complementary measures, the
aggregate price-to-book value ratio and the aggregate price-to-trailing 12-month
earnings ratio. The two top charts in Exhibit 10 show these two ratios for developed
and emerging markets, while the bottom charts show the relative valuation of
emerging markets compared to developed markets. The relative valuation charts
have a simple and intuitive interpretation: They effectively show the percent premium
or discount of emerging markets relative to developed markets. We also plot the in-
sample mean and standard deviation of the two relative valuation measures.

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

Exhibit 10: Valuations of Emerging Markets

Focusing on price-to-book value, we note that emerging markets have been trading at
a discount relative to developed markets for most of the last 20 years, averaging
close to 20%. As of Jan. 31, 2019, the discount was closer to 30%, suggesting that
emerging markets currently had moderately attractive valuations compared to
developed markets and relative to the historical relationship between the valuations
of the two markets. With respect to price-to-earnings, emerging-market valuations
appeared closer to neutral, trading at a discount that was in line with the historical
average discount, relative to developed markets.
Has there been a relationship between relative valuations and subsequent
performance? In Exhibit 11, we examine this relationship over different horizons.
Over one year, the relationship was negative (lower valuations were associated with
higher performance) but weak, indicated by an almost flat regression line and lack of
consistency in quintile performance. On the other hand, when we examine
performance over five years, the relationship became stronger, reflected in a steeper
regression line and more consistent quintile rankings. In summary, relative valuations
have historically been associated with subsequent performance over long horizons
and recent valuations were neutral or moderately attractive, compared to historical
levels. In fact, given the robust long-term macroeconomic outlook for emerging
markets (see Exhibits 4-7), investors may start to question the magnitude of the EM
valuation discount.

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Exhibit 11: Relative Valuations and Subsequent 1-Year Outperformance

Exhibit 12: Relative Valuations and Subsequent 5-Year Outperformance

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

SOURCES OF RISK AND RETURN IN EMERGING MARKETS

Various options are available for portfolio construction, once investors decide to
make an allocation to emerging markets, including:
• Country allocation
• Security selection
• Factor mandates
• Integration of ESG
To evaluate these options, we examine the relative importance and contribution of
different sources to risk and performance in emerging markets. Cross-sectional
volatility (CSV), defined as the standard deviation of returns across stocks in a given
universe and over a given period, is often used as a proxy for the potential to add
value from active portfolio management. Exhibit 13 shows CSV for developed and
emerging markets. We used MSCI’s Barra Global Equity Model for Long-Term
Investors (GEMLT) to decompose CSV into country, industry, style and specific
sources.
Exhibit 13: Cross-Sectional Volatility of MSCI World IMI and MSCI EM IMI

Total CSV, a proxy for the potential added value from active management in general,
is higher in emerging markets, even though the number of constituents is

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

significantly lower than in developed markets. In addition, the contribution of specific

CSV, a proxy for potential added value from security selection, has been higher in
emerging markets, especially during the 10 years to 2019. The charts on the right
break down common factor CSV into country, industry and style factor contributions.
Countries are the dominant source of common factor CSV in emerging markets,
accounting for more than 60%, while industries and styles each contributed less than
20%. In contrast, countries are the least important source of CSV in developed
markets while industries and styles are more important, with styles contributing more
in volatile market conditions.
We explored the contribution of different sources of portfolio risk and performance
by examining and decomposing the diversification ratio of developed and emerging
markets. This ratio compares asset-level-weighted average risk and portfolio level
risk, at different levels of aggregation, as follows:

𝑤𝑤𝑤𝑤𝑤𝑤 𝑎𝑎𝑎𝑎𝑎𝑎 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑤𝑤𝑤𝑤𝑤𝑤 𝑎𝑎𝑎𝑎𝑎𝑎 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑤𝑤𝑤𝑤𝑤𝑤 𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑤𝑤𝑤𝑤𝑤𝑤 𝑎𝑎𝑎𝑎𝑎𝑎 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
= ∙ ∙
𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑤𝑤𝑤𝑤𝑤𝑤 𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑤𝑤𝑤𝑤𝑤𝑤 𝑎𝑎𝑎𝑎𝑎𝑎 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟

Global Diversification Stock Diversification Country Diversification Region Diversification

Exhibit 14 plots the total diversification ratio (left side of the equation) and its three
components, namely, region-, country- and stock-level diversification ratios (right
side of the equation). The total and stock-level diversification ratios have been higher
in emerging markets during the analysis period. These observations highlight the
availability of active stock-selection opportunities in a diverse universe of securities,
as well as potential risk reduction through diversification at the global level during
this timeframe. In addition, the country diversification ratio that compares country
and regional risk has been lower in emerging markets compared to developed
markets. These results are consistent with the earlier cross-sectional volatility
analysis and further illustrate the historical impact of the country factor in emerging
markets.

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Exhibit 14: Rolling 12-month Diversification Ratio for DM and EM

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

Further evidence of the importance of countries in emerging markets is provided in

Exhibit 15, where we plot pairwise country correlations in emerging and developed
markets. These correlations were lower in normal market conditions and increased
during periods of heightened market volatility. However, emerging-market country
correlations have remained substantially lower relative to developed markets during
the two decades through 2018. Low country correlations in emerging markets have
important implications for different investment strategies. Specifically, global index-
based strategies may experience reduced volatility due to country diversification
while global active strategies may benefit from a diverse country selection
opportunity set.

Exhibit 15: 3-year Rolling Country Correlations in Emerging and Developed Markets

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

Exhibit 16: Price-to-Book of Largest EM Countries Relative to MSCI EM Index

Having established the importance of countries as drivers of risk and performance in

emerging markets, we examine country valuations and assess their historical track
record in guiding country allocation decisions. Exhibit 16 shows the current relative
valuations of the largest emerging-market countries and compares them with their
historical levels. Russia and Korea have historically traded at a discount relative to
other emerging markets, and that discount was even wider as of Jan. 31, 2019,
suggesting that the two markets enjoyed moderately attractive valuations. India and
Thailand, on the other hand, have traded at premium valuations in the past and that
premium was high, indicating that the two markets had relatively expensive
valuations.

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Exhibit 17: Starting Valuation and Subsequent Outperformance

Data from Dec. 31, 1998 to Jan. 31, 2019

We illustrate the historical relationship of country level relative valuations and

subsequent country index performance over different investment horizons in Exhibit
17. Consistent with the global emerging markets results presented in Exhibits 11 and
12, we found that country-level valuations had a negative relationship with
performance — that is, higher valuations preceded weaker performance and vice

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

versa — and the relationship became more consistent as we increased the holding
period.
In Exhibit 18, we show quartile returns of emerging-market countries selected based
on absolute valuations and confirm that lower valuations were associated with
higher average returns historically. For every month during the analysis period, we
sorted emerging-market countries by price-to-book and price-to-earnings ratios, and
calculated the return of equal-weighted quartile portfolios over the next month.
These results suggest that country-level valuations could have been used as an input
into active asset allocation strategies in emerging markets during the study period.
Exhibit 18: Country Valuations and Subsequent Outperformance

Another important, but sometimes overlooked, element of managing an emerging-

market portfolio is currency risk. Equity investors often accept currency exposure as
a component of the total risk of a global emerging-market equity portfolio. Our
research 3 showed that over a 10-year period from 2007-2017, the unhedged MSCI
Emerging Markets Index would have outperformed the hedged variant. However, with
emerging-market currency volatility increasing in the last few years, investors may

3
Aylur Subramanian, R. “Does Turkey offer lessons for managing emerging-market currency volatility?” MSCI.com, Aug.
15, 2018.

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

choose to use currency volatility as an indicator to monitor currency risk and guide
currency hedging decisions.
Next, we examine the integration of factor and ESG information in index-based
strategies and active fundamental portfolios in emerging markets. Specifically, we
focus on the following factor investing strategies and use the corresponding MSCI
Factor Indexes as proxies:

Factor MSCI Factor Index

Value MSCI Enhanced Value Index
Low Size MSCI Equal Weighted Index
Momentum MSCI Momentum Index
Low Volatility MSCI Minimum Volatility Index (Min Vol)
Quality MSCI Quality Index
Yield MSCI Quality Index
Risk Parity MSCI Risk Weighted Index
MSCI Diversified Multiple Factor Index
Multi-factor (DMF)

We show the performance of these factor investing strategies in emerging markets

in Exhibit 19. These strategies have produced active returns ranging from 0.7% to
4.7% per year in emerging markets during the last 20 years. This analysis suggests
that the same factor investing strategies that many investors use in developed
markets could have been deployed successfully in emerging markets during our
study period.

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Exhibit 19: Performance of Factor Investing Index Strategies in Global EM

We have observed that institutional investors increasingly consider the potential

significance of Environmental, Social and Governance (ESG) issues and seek to
integrate ESG criteria in the investment process. So, we now turn our attention to
ESG integration in emerging markets. Specifically, we look at four different ESG
integration strategies, using the following MSCI indexes as proxies:

ESG integration strategy Index name % of parent index

Index reweighting MSCI ESG Universal Index Approx. 100%
Best-in-class selection MSCI ESG Leaders Index Approx. 50%
Optimized integration MSCI ESG Focus Index Approx. 33%
High conviction integration MSCI SRI Index Approx. 25%

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

Exhibit 20: Performance of ESG Integration Index Strategies in Emerging Markets

Exhibit 20 shows that the four ESG index integration strategies we examined
outperformed the MSCI Emerging Markets (EM) Index during the analysis period (we
are limited to a shorter period during which ESG data was available). In addition, all
four strategies experienced lower realized volatility and superior risk-adjusted return
(Sharpe ratio) compared to the MSCI EM Index.
Having examined strategies for integrating factor and ESG information into
emerging-market indexes, we now turn to the topic of active management and
specifically the integration of factor and ESG information into active emerging-
market portfolios. We analyzed a sample of 90 actively managed global emerging-
market funds from the Lipper database for which we had data during the period April
2010 to February 2019 and divided them into quartiles based on their rolling 5-year
active return, relative to their benchmarks. For reference, we also analyzed 360
actively managed global developed market funds from Lipper for which we had data
over the same period. Exhibit 21 shows this analysis, confirming that most actively
managed emerging-market funds in our sample outperformed their benchmark
during the analysis period, and that outperformance was greater in emerging
markets than in developed markets, before transaction costs and management fees.

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

Exhibit 21: 5-year Returns of Actively Managed EM and DM Funds

To assess the efficacy of ESG integration in active emerging market portfolios, we

follow the process outlined in Giese et al. (2018) and simply screen out the 10%
worst ESG-rated stocks from the active portfolios we analyzed. In addition, to
evaluate the impact of incorporating factor information into these portfolios, we tilt
the remaining holdings toward the eight main equity factors, following the process
described in Melas et al. (2019). The results of this analysis are summarized in
Exhibits 22 and 23.
Exhibit 22 reveals that screening out the 10% worst ESG-rated stocks from the
actively managed emerging-market portfolios in our sample led to a modest
improvement in their 5-year annualized return. Furthermore, when we tilted the
remaining holdings toward the main equity factors, there was a further, more
significant uplift in performance. Exhibit 23 shows that the resulting modified active
portfolios experienced a substantial enhancement in their sustainability profile. This
analysis shows that actively managed emerging-market strategies could have
benefitted from integrating factor and ESG information.

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

Exhibit 22: Rolling 5-year Returns of Actively Managed EM Mutual Funds

Exhibit 23: Active ESG Score of Actively Managed EM Mutual Funds

CHINA AND THE FUTURE OF EMERGING MARKETS

The emerging-market universe has evolved through time, reflecting economic and
market changes, as well as the evolution of the institutional investment process. In
the last few years, this process has been dominated by the gradual liberalization of
the domestic Chinese equity market. The Chinese authorities have implemented a
series of equity market reforms, aiming to attract foreign long-term portfolio
investments and support the country’s transition from manufacturing and exporting
to a consumption-driven economy.

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

Exhibit 24: China’s Market Liberalization and the MSCI Index Methodology

Exhibit 24 chronicles the main equity market liberalization measures implemented by

the Chinese authorities and how the market opening process has been reflected in
the MSCI index methodology. The market first became accessible to a few large
foreign institutions in 2002, when the Chinese authorities launched the Qualified
Foreign Institutional Investor (QFII) scheme. The process started to accelerate in
2013, when capital repatriation rules were relaxed and the RQFII scheme was
extended to multiple locations. That was the time when MSCI first opened a
consultation on the inclusion of domestic Chinese equities in the MSCI Emerging
Markets Index.
The opening of the Chinese market and MSCI’s index consultation process have
progressed in parallel over the past five years. The introduction of the Stock Connect
scheme, which does not require investor registration, and its extension to cover both
main Chinese exchanges (Shanghai and Shenzhen), were the catalysts that led to the
inclusion of A shares in MSCI indexes in May 2018. As the pace of regulatory reform
and market liberalization has accelerated in the last 12 months, MSCI has announced
that the weight of A shares will be further increased from the current 5% to 20% of
their free float, in three steps between May 2019 and the end of the year.

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

Exhibit 25: Increase of the Weight of A shares in the MSCI Emerging Markets Index

Data as of Jan. 22, 2019.

Exhibit 26: Relative Market Size and Economic Importance of Emerging Markets

© 2019 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document. MSCI.COM | PAGE 29 OF 33
 THE FUTURE OF EMERGING MARKETS | APRIL 2019

CONCLUSION
As Exhibit 3 shows, emerging markets have delivered superior returns and greater
volatility than developed markets in the last 30 years. The forces that are likely to
shape the future of the equity segment in the coming decades include economic
growth and fiscal discipline, ongoing capital market liberalization, the further
adoption of free market policies, the emergence of world-class companies and the
transition from natural resources extraction, manufacturing and exporting to higher
added value economic activity and domestic consumption. As Exhibit 26 highlights,
emerging markets represent only 12% of global equity free float, but their weight
increases to approximately 20% by total market cap and to 40% of global economic
activity (GDP) and share of company revenues. These observations underscore the
central role that emerging-market allocations will likely continue to play in global
equity portfolios in the future.

The author would like to thank his colleagues Akshay Baht, Navneet Kumar and Zoltan
Nagy for their substantial and valuable contributions to the research presented in this
paper.

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 THE FUTURE OF EMERGING MARKETS | APRIL 2019

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Markets.” ETFs and Indexing, No. 1, pp. 118-122.
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