Should Investors Consider Disaggregating Their Emerging Markets Exposure?

Strategists are often quick to group economies with an acronym or catch-all term but very rarely do the participants of those groups exhibit the same risk and return characteristics.

The war between Russia and Ukraine is yet another example of why emerging market countries should not be viewed as one homogenous group. More recently there has been a trend of investors starting to disaggregate the individual country constituents of emerging markets and invest on a more nuanced country-by-country basis.

Since Jim O’Neil created the term BRIC in 2001, the annualised returns of Brazil, Russia, India, and China have been 7.8 per cent, -42 per cent, 11.2 per cent and 8.2 per cent respectively.

The differing drivers of performance and volatility for these markets over time have been clear.

More recently Brazil has suffered the Lava Jato crisis starting in 2014, China faces a real estate crisis that is still playing out, and now Russia is being removed from many EM indices (reflected in the annualised underperformance highlighted above). India, meanwhile, had repeated periods of underperformance but has shown decent returns more recently, especially after the covid crash in early 2020.

There are structural reasons why investors have been increasingly interested in disaggregating emerging market exposures.

For example, China, a market that represents approximately 30 per cent in broad EM indices, is no surprise as China is the second-largest economy in the world and a giant in almost every other sense as well. As a result, investors have been incentivised to increasingly carve out their China allocation from their broader emerging market exposures.

This is due to a mix of increased risk appetite as investors seek yield, structural changes which have opened Chinese markets to foreign investors, and further diversification within the Chinese economy.

China is the most prominent example. However, there is also a case to be made about the differing risk-return profiles in emerging markets more generally. Drivers for risk and return in emerging markets have changed and diverged significantly over the past two decades.

Take the two contrasting examples of Brazil and Taiwan. Brazil stands to be a beneficiary of the war in Ukraine due to a surge in commodity prices and its position as a key commodity exporter. There are some headwinds for Brazil as an agricultural exporter, which means it could face higher fertiliser and energy costs as supply from Russia is curtailed by the conflict.

Taiwan, on the other hand, is a country that has and should continue to benefit from the global demand for technology. Taiwan’s annualised performance from 2001 is 9.4 per cent. Taiwan is a country with a strategic geographical location, with a high weighting on technology (particularly semiconductors), and with exports accounting for well over half of its GDP. China is Taiwan’s largest trading partner with a share of over 26 per cent of total trade. The United States comes second at 13 per cent, followed by Japan (11%), the European Union and Hong Kong (both 8%).