Emerging Markets: Evidence for a premium?

When considering global capital markets from an investment perspective, it’s second nature to divide the world into “developed” vs “emerging”. Index providers allocate countries to either classification depending on their stage of economic development and its sustainability. The two characteristics considered are “investability” such as size and liquidity, and then accessibility, which considers factors such as foreign ownership limits, ease of capital flows and operational stability. (1) Emerging economies are often associated with increased risk of inflation, geopolitical uncertainty and foreign exchange fluctuations. The overall systemic, or “market” risk, is elevated, resulting in a bumpier investment ride.

Given these risks, what is the rationale for investing in these economies?

Beta-convergence. This macroeconomic growth theory predicts that emerging economies will grow faster than their developed counterparts, until they reach the same level of economic development. Economic growth within a country is important to investors as over the long term, this is the main driver of a country’s equity market value. If Beta-convergence holds, by investing in countries with faster-growing economies, investors should receive a greater return. The evidence suggests that emerging markets may converge (2) and thus experience higher rates of economic growth – which is subject to the adoption of appropriate economic, legal and political reforms.

Is there a potential premium to be gained from emerging markets?

To answer this, we observed the risk-adjusted returns of emerging market equities and developed equities over annualised rolling periods of 5-, 10-, 20- and 30-years. We also examined the growth of a £1 investment over time, using data from 1926 to 2020. Finally, we explored the possibility of a change in trend over the last 20 years between the performance of developed equities and emerging equities.

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1 - There is no universally agreed upon criteria for classifying economies as developed or developing (emerging). The IMF
classifies 34 economies as developed and 150 as developing (emerging). It says that “this classification is not based on strict criteria, economic or otherwise and has evolved over time” (IMF 2011)
2 - IMF. 2011 Statistical Appendix In World Economic Outlook (September). Washington, DC: International Monetary Fund.