Investors are underinvested in EM, no matter how you cut it

In this Emerging Markets Special Topics commentary, we engage the issue of “What is the optimal emerging markets (EM) allocation in a global portfolio?,” which is a question we are frequently asked by clients and consultants. Unfortunately, there is no one way to answer the question, so here we try to approach it from multiple angles. These include examining both fundamental economic and market-based approaches to sizing an emerging markets allocation. In our view, no matter how you cut it, there is an argument that investors are currently underinvested in EM. All three methods we examine in this commentary suggest that the optimal EM share in global portfolios is well above what most allocators currently hold.

GDP-weighted Approach to EM Allocation

The first approach we examine posits that the size of EM’s allocation in a global portfolio should reflect its relative size in the global economy. The intuition here is that a portfolio of financial assets should mirror the “real” economic importance of its constituents. As such, there are two ways to measure EM’s relative economic importance: EM’s outright share of global GDP (measured in USD), or alternatively EM’s contribution to global GDP growth. In sum, EM presently accounts for a 41% share of global GDP and has been contributing 43% to each year’s global economic growth. Clearly, in recent decades those numbers are dominated by one country: China. Excluding China, EM’s share in global GDP drops to 23% while its contribution to growth falls to 38%.

Mean-variance Optimization Approach to EM Allocation

Another approach to estimating the optimal EM allocation is to run traditional mean-variance optimizations using historical returns and volatility. That approach calculates the EM weighting that maximizes return while minimizing volatility. In the calculations, we used monthly return data since 1999 and performed the analysis separately for a pure equity portfolio and for a pure fixed income portfolio.

For equities, we built a portfolio that included four indices: U.S. equities (S&P 500), European equities (EUR Stoxx), Japanese equities (the Nikkei index) and Emerging Market Equities (MSCI Emerging Markets index). Moreover, for EM, we ran the analysis separately for a portfolio that includes China and one that excludes it. The results for the analysis are displayed in the full report. The quantitative exercise would suggest that the optimal allocation for an equity portfolio is 8% of EM with China included, and excluding China, the share rises slightly to 9%.

Allocation approach based on EM’s share in global market indices

The final approach to understanding what the optimal emerging markets portfolio allocation may be examines the share of EM in global indices. Our intuition here is that the asset allocation should arguably be driven by the size of EM tradable securities in global financial markets. The broadest metric we looked at includes the ratio of all listed EM issuers. Using that broad definition, listed EM companies have an equity market capitalization equivalent to 31% of global stock market capitalization, and excluding China, the share is around 16%. In fixed income, EM’s share comes to 23% and 10% if one were to exclude China, according to Bank of America research¹.

However, in our view, the above metric is too broad since it does not control for liquidity, free-float and issue size. We used MSCI and Bloomberg indices to account for those factors. More specifically, for equities, the data shows that the share of EM in MSCI ACWI comes to 11% (8% excluding China). For fixed income, EM accounts for 12% of the Bloomberg Global Bond Aggregate index (IG, HY, Inflation linked, Munis) and ex-China that ratio drops to 8%.

• The first approach relies on the “real” economic weight of EM. Unadjusted, the approach pointed to an allocation of 40% for EM (including China). However, our quantitative estimate of growth-detracting adjustments suggested to an optimal EM allocation closer to 30%.
• The second method, based on optimizations of historical returns and volatility, suggested an EM allocation of around 9% for EM equities and another 10% for fixed income.
• Finally, the third method looked at EM’s index market share. Adjusted for liquidity and other market depth considerations, the resultant optimal EM allocation is around 12% for both equities and bonds.

How do those methods compare to actual holdings by investors? For equities, available data suggest an allocation to EM equities of around 6.4%². For fixed income, available data³ for European investors suggest an average EM allocation of 5% while for US investors, the estimate is around 1-2%. In a separate analysis of the largest global bond funds holdings, J.P. Morgan found that two-thirds of the funds have less than 10% of AUM in EM government debt⁴. Therefore, in our view, all three methods above suggest that the optimal share of EM in global portfolios is well above what most allocators currently own.