Investors need to rethink how they define emerging markets and shouldn’t expect the same heightened levels of returns moving forward, according to Somerset Capital Management’s Edward Lam.
Since 2001 emerging markets have been a much better proposition for risk-on investors, outperforming their developed market peers by more than triple, as the below chart shows.
It should be noted that this period comes directly after the emerging market crisis of the late 1990s but FE’s total return data does not extend further.
Performance of indices since Jan 2001
Source: FE Analytics
“The history of emerging markets comes from the 1980s [when] they were literally emerging and more importantly from my point of view they were integrating with western capitalist markets and systems and becoming part of the international trade community,” said Lam, who manages the MI Somerset Emerging Markets Dividend Growth fund.
“Historically, they [emerging markets] were third world countries and a lot of [them] were Soviet bloc countries moving out of communist spheres of influence back into capitalist markets.”
The fund manager noted however that the composition of emerging markets has changed in the past couple of decades and that there are few new countries integrating into capitalist system.
This may hamper returns in the future, Lam explained, as the biggest leap forward in GDP per capita and GDP growth has generally been at the point that smaller countries begin integrating with capital market systems.
He explained that countries integrating with the capital markets initially receive a huge amount of foreign direct investment and capital flows as well as a massive bump in terms of trade with the rest of the world.
“The problem with the definition of emerging markets that indices have now is that they have just used the markets that were emerging markets historically and effectively rolled forwards 20 years,” Lam said.
“I looked at a map of the MSCI’s emerging markets in 1990 and an interesting trivia question is how many of those emerging markets have actually made it to developed market status?
“Nearly 30 years of development – so there is radical change – yet there is not one single market on that map that is a developed market and that is just not true.”
There are two countries that have made it to developed market status however. Israel was not an emerging market in 1990 having previously been considered a frontier economy, while Greece was downgraded to the MSCI Emerging Market after the European sovereign debt crisis.
Conversely there are some economies such as Trinidad & Tobago that were considered emerging by the MSCI’s standard but have slipped back into the frontier markets basket.
However, many of the countries on the list should now be classed as developed countries by the MSCI and other index definitions, according to Somerset’s Lam.
Source: MSCI
“If you think about what was developed then in 1990 many of these markets have surpassed the levels of development that developed markets had,” Lam said.
“If you take Korea for example, just in terms of telecoms infrastructure, calling it an emerging market is a bit of a joke.
“The reason that we still call things ‘emerging’ and ‘developed’ in my view has got very little to do with any particular criteria, even though the MSCI and the FTSE will set certain criteria such as GDP per capita, market access, corporate governance and stuff but it is all very wishy-washy.”
There are reasons why these countries have not made it to developed market status, the manager argued.
From an asset allocation point of view clean, simple distinctions and definitions make it easier to distinguish countries while the markets themselves would rather be a larger part of the emerging markets index than a rounding error in the developed world index.
The only constituent of the index therefore with the potential to move from emerging to developed status in the coming years is China.
“Over the last 10 years it has actually been one of the more classic emerging markets,” Lam said as it fits the definition of the 1980s and 1990s in that it very much has been – and still is – in the process of integrating into the global capitalist system.
But it also fits in with what he believes should be the requirement for developed markets – a market in a country that forms part of the world’s dominant and subordinate capital and currency blocs.
“Currently the dominant capital and currency blocs are the US, Europe and maybe Japan and there are a few satellites around that such as Australia and Canada to the extent that those currencies have some sort of reserve-like status,” he said.
“China in the context of my definition of emerging is one of the few that can become a non-emerging market because it could become a dominant capital and currency bloc where Korea won’t be and Taiwan can’t be and never will be.”
As such, these countries are destined to be “perpetual emerging markets”, although Lam (pictured) suggested “satellite countries” may be a more appropriate term. 
But under the manager’s definition it would make sense that China is the country to become developed – even if it is less technologically developed and has a lower GDP per capita than Korea – under the definition that it becomes a dominant capital and currency bloc.
So what can you expect to see moving forward? Well Lam said that as many of the emerging markets have now integrated investors are unlikely to see the extreme difference in returns that we have since the turn of the century.
“I think returns are still going to be slightly higher but I don’t think that you get the ‘wipe the floor’ type performance,” he said.
As well as this, the region is unlikely to offer the diversification some may have been holding it for historically.
The manager said: “The secret that has been kept hidden for historical reasons is that one of the biggest arguments for allocations to emerging markets was – yes, higher expected performance – but in addition to that very low correlation to developed market asset class.
“Therefore it was an efficient asset allocation in terms of your risk frontier and that was a classical case made for emerging markets made back in the 1990s.
Rolling 1yr R-squared of MSCI Emerging Markets to MSCI World
Source: FE Analytics
“That isn’t the case anymore. The emerging markets are much more correlated because they have gone through the integration process,” he added. “The integration process boosts returns but also unfortunately brings countries into line and the correlations are a lot greater overall.”
As such, investors looking to take advantage of this next wave of integration should be looking further down the market at those in the frontier bucket.
“If you look back at what was an emerging market in 1990 they are generally speaking a lot closer to what frontier markets look like now,” Lam said.
“Part of the reason people don’t want to say that [the next generation of emerging markets are frontier markets] is for commercial reasons. You have got all these emerging market managers who manage a lot of money but wouldn’t if we were just frontier investors and that is exactly it.”