Have Emerging Markets Emerged?

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After much talk post-global financial crisis that emerging markets have emerged, the so-called emerging markets “taper tantrum” in 2013–2014 seems to have completely changed that perception.

So have emerging markets really taken their place among the other investment asset classes? The answer is not only intellectually intriguing but also has real implications for investors worldwide.

How did the question come about?

The term “emerging markets” was coined by Antoine van Agtmael, an executive at the World Bank’s International Finance Corp. (IFC), in 1981. At that time it was merely a euphemism for “third world” in much the same way that “high yield” was invented by bankers to replace “junk bonds.”

MSCI launched the MSCI Emerging Markets Index in 1988. Since then emerging markets as a whole have gradually become an independent asset class. Still, for many years, emerging markets were associated with high growth potential — and high risk.

Fundamentals improved significantly in the decade of 2000s, so much so that there was increasing talk that emerging markets had come into their own . . . until the taper tantrum hit, that is. In our usual collective wisdom, we have come to wonder, is the taper tantrum here to stay? It’s interesting how fast our beliefs can change over a matter of months.

(Note that our discussion here is equity-focused. For an analysis of emerging market debt, please see “What Makes Emerging Market Debt Tick?” and “Emerging Market Debt: An Overlooked Source of Alpha?”)

What makes emerging markets “emerging”?

So what distinguishes an “emerging” market?

The IFC defines a market as emerging if it is in a low- or middle-income economy as characterized by the World Bank, or has a low investable market capitalization relative to its GDP. According to the IFC, emerging markets are characterized by “increasing size, activity, or level of sophistication.”

Two things stand out in the classification criteria: First, these markets offer strong growth potential. Second, the institutions in these markets are not yet fully developed.

Most investors intuitively grasp the first component of the criteria, partly because it is both exciting and easier to see. The second aspect seems like more of a downer and is generally tougher to measure. However, seasoned investors appreciate how important it is to understand the risk element in any investment decision. After all, as Warren Buffet has famously said, “you only find out who is swimming naked when the tide goes out.”

Which market institutions make emerging markets “emerging”?

So what market institutions are responsible for holding emerging markets back? Cornell University professor G. Andrew Karolyi’s keynote speech, “Cracking the Emerging Markets Enigma,” at a recent academic conference, seems to have provided some of the answers we are looking for.

A large institutional investor approached Karolyi before the global financial crisis to help develop some objective criteria assessing the investment desirability of various countries. They naturally suspected that the following factors may come into play: market capacity constraints, operational inefficiencies, foreign investability restrictions, the quality of legal protections for minority investors, corporate governance, and disclosure issues. Karolyi’s multi-year project eventually culminated in a risk index based on existing academic research along these six dimensions. A large amount of data for a wide selection of countries has been examined.

The index demonstrates that there is a gap between the developed markets and emerging markets in terms of the quality of market institutions. More importantly, the index was helpful in explaining the capital outflows from various “emerging markets” during the 2013–2014 taper tantrum. The overall risk index proved relevant and the most prominent factors were what Karolyi called limits to legal protections, operational inefficiencies, and political instability.

So have emerging markets emerged? Karolyi’s research seems to indicate that they haven’t. The market test is quite powerful: Despite improvement in “hard” economic numbers such as GDP and market capitalization, the “soft” aspects of institutional development have left long-lasting impressions in investors’ minds, the data shows. In a “risk-off” scenario like the taper tantrum, investors will vote with their money. And that is far more important than any index vendor’s classification criteria.

For more details on Karolyi’s research, please read the next installment in this emerging markets series: “Where to Invest in Emerging Markets: Lessons from the Taper Tantrum.”

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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