Emerging Markets (EMs) – typically lower-income nations that are less economically advanced relative to those in Western Europe, North America, Japan and Australia – can provide investors with valuable global diversification opportunities, in Fisher Investments UK’s view. But many commentators we follow present EMs as risky markets featuring vibrant, rapidly growing economies – the surefire investing winners of the future, if you can stomach the volatility. We guess the name plays into that. They are, after all, Emerging Markets – not submerging markets. However, Fisher Investments UK’s research suggests not all EMs carry comparable levels of return and risk. We think this variance is important for investors to understand when approaching EM investing.
There is no universal standard for what constitutes an Emerging Market, but we focus here on index provider MSCI’s criteria due to its investing relevance. MSCI uses several criteria – “Economic Development”, “Size and Liquidity” and “Market Accessibility” – to classify countries as Developed (DM), Emerging (EM), Frontier (FM) or Standalone.i The Economic Development criterion is based on a country’s gross national income (GNI) per capita, a measure denoting the dollar value of a country’s annual income divided by its population. Per MSCI, EMs don’t have an Economic Development requirement – a contrast to DMs, which must have a GNI per capita that is 25% above the World Bank “high income threshold” (currently $12,536) for three consecutive years.ii
Rather, MSCI focuses on financial and market development. It requires EMs to have at least three constituents meeting certain market capitalisation (a measure of company size calculated by multiplying shares outstanding and current share price), security size and liquidity (the ease in which a security can be converted into cash) thresholds. Finally, MSCI evaluates a country’s Market Accessibility, including its openness to foreign investment, ease of capital flows and stability of national institutions. For example, the UK, a DM, is a parliamentary democracy with a sterling reputation for safeguarding property rights – a contrast to EM Turkey, where institutions are more vulnerable to political interference, according to Fisher Investments UK’s research.
Whilst EMs share some characteristics, they can also vary greatly. For example, even though South Korea has the Economic Development and Size and Liquidity requirements of a DM, MSCI designates the country as an EM on Market Accessibility grounds. Korean exchanges forbid short selling (selling borrowed securities with the aim of profiting from their price declining), and the country doesn’t have an offshore currency market (currency cannot be traded internationally).iii Another EM, Taiwan, is the world’s primary semiconductor producer and also meets MSCI’s Economic Development and Size and Liquidity requirements for a DM.iv But MSCI designates Taiwan as an EM due to its currency not being freely convertible (it cannot be easily exchanged for a foreign currency) and its exchanges’ not being fully modernised (including a “significant amount of paperwork”).v
On the other end of the spectrum, we have Peru. It is a copper-mining powerhouse and, in our view, benefitted from several free-market reforms in the 1980s. Yet it still has minimal global economic impact (it represents only 0.18% of global GDP) and even lower market accessibility than Korea and Taiwan.vi MSCI Peru contains just three equities, with a combined $13.7 billion market capitalisation.vii Peru even skirted FM reclassification in 2016 due to its constituents’ low liquidity – and one constituent almost being reclassified as not Peruvian.viii
In our view, EM classification doesn’t mean a country is on an unstoppable economic ascent – even if an EM seems promising now. Yes, Israel is a success story in this sense. In May 2010, MSCI moved it from EM to DM.ix Its economy features a GNI per capita of $42,600 – more than triple the World Bank’s high income threshold – and a booming Tech sector. x But Greece went in the opposite direction. Though MSCI moved it from EM to DM in May 2001, it later reclassified Greece to EM in November 2013, during its debt crisis, after the country failed to meet size criteria and requirements for security borrowing and lending.xi
Even if an EM appears set to soar, nothing is certain. Consider Russia, now a former EM. Twenty years ago, commentators we follow hailed Russia as one of the fastest-growing economies alongside Brazil, India and China (together dubbed “BRIC” nations) – with some predicting Russia would be a dominant global economy by 2050, rivalling even the US.xii Reality hasn’t played out that way. Its economy remained dependent on commodity exports, its government remained authoritarian and militarily adventurous, and MSCI reclassified the country to Standalone following Russian President Vladimir Putin’s invasion of Ukraine. xiii This serves as a warning to investors, in our view: distant projections are just that, and EMs may fail to live up to those visions.
Yes, investing always comes with a risk and reward trade-off. But we think investors benefit from recognising EMs’ potential upside may also come with potential downside.
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i “MSCI Market Classification Framework,” MSCI, June 2021.
ii Source: World Bank, as of 16/03/2022, and Ibid.
iii Source: World Bank, as of 16/03/2022. Korea Index (USD) and South Korea GNI Per Capita, 1962–2022. Presented in US dollars. Currency fluctuations between the dollar and pounds may result in higher or lower investment returns, and “MSCI Global Market Accessibility Review,” MSCI, June 2021.
iv “2 Charts Show How Much the World Depends on Taiwan for Semiconductors,” Yen Nee Lee, CNBC, 15/03/2021, and see note i.
v “MSCI Global Market Accessibility Review,” MSCI, June 2021.
vi Source: World Bank, as of 16/03/2022. Statement based on Peru GDP at year-end 2020, in US dollars. Currency fluctuations between the dollar and pounds may result in higher or lower investment returns.
vii Source: FactSet, as of 16/03/2022. Statement based on MSCI Peru Index constituents. Presented in US dollars. Currency fluctuations between the dollar and pounds may result in higher or lower investment returns.
viii “MSCI Keeps Peru as ‘Emerging Market’,” Colin Post, Peru Reports, 17/06/2016.
ix “Update 1 – MSCI Ups Israel to Developed Mkt; Mulls Korea, Taiwan,” Walter Brandimarte, Reuters, 15/06/2009.
x Source: World Bank, as of 16/03/2022, and “Tech Sector Leads Israeli Exports, Projected to Reach Record High of $140b in 2021,” Ricky Ben-David, The Times of Israel, 27/12/2021.
xi “MSCI Downgrades Greece Index to Emerging Market Status,” Nyree Stewart, FT Adviser, 12/06/2013.
xii “Whatever Happened to the Brics Economies?,” Andrews Walker, BBC, 27/11/2014.
xiii Source: World Bank, as of 16/03/2022. Russia GDP (current US$), 1990–2020 [Russia was 2.3% of global GDP in 1990 vs. 1.8% in 2020. Presented in US dollars. Currency fluctuations between the dollar and pounds may result in higher or lower investment returns], and “MSCI Removes Russian Securities From Emerging Markets Indexes After Deeming Them ‘Uninvestable’,” Nasdaq, 03/03/2022.