Our Insights

April 2011

The Case for Diversified Emerging Markets Exposure

Mary Jo Palermo, Eric Winig, and Greg Moessing

Many investors believe, as we do, that emerging markets offer a more compelling long-term growth story than do developed markets, and that portfolios should be tilted toward such regions to participate in this growth. However, before committing more funds to the area, investors should first re-evaluate how they allocate their exposure. While most allocations currently consist of long-only strategies that use the MSCI Emerging Markets Index as a benchmark (or invest in the index itself), such strategies tend to be overly concentrated in certain regions and countries; further, they often provide exposure to large multinationals (e.g., Gazprom, Petrobras, and Samsung) as opposed to smaller firms more directly exposed to emerging markets economies. In simple terms, most investors in emerging markets are essentially invested in large multinationals based in the BRICs (Brazil, Russia, India, and China), while many of the most compelling opportunities are to be found elsewhere, whether in smaller markets and/or companies, or different asset classes such as debt or even currency.

“Investors considering larger allocations should look to implement an emerging markets strategy with broad exposure across several asset classes.”
Thus, while current allocations are fine as far as they go—in essence, they provide a decent amount of emerging markets beta and generally require relatively little oversight—investors considering larger allocations (e.g., significantly more than 5% of the total portfolio) should look to implement an emerging markets strategy with broad exposure across several asset classes. In short, such a program should more closely resemble the portfolio’s developed markets investments, with the goal of generating equity-like returns at lower volatility over the long term, and more meaningfully exploiting inherent inefficiencies in the emerging markets universe.

This is easier said than done, of course—investing in smaller companies, frontier countries, and local currency debt markets exposes one to a different set of risks not so easily quantified, and as such requires a greater level of sophistication and oversight, both on the part of investors and managers. Indeed, while our assumption in this paper is that an investor has already decided to implement a larger-than-typical allocation to emerging markets, such a strategy exposes one to different risks, regardless of the way it is implemented—for example, a “hard landing” in China or continued turbulence in the Middle East are just two of the many scenarios that could upend the positive outlook for emerging markets. However, for those that believe an expanded emerging markets allocation makes sense, adequate diversification is critical—a program without such diversification would in essence be exposing a large portion of assets to a fairly narrow strategy with a history of dramatic ups and downs.