According to a recent survey by Mallowstreet, 90% of its UK institutional investor respondents are either retaining existing allocations to emerging markets (EM) or increasing them. Only 2.5% are decreasing, and 7.5% still have no allocations.

What should these investors be looking for, both in terms of investment opportunities and the underlying factors driving them? What is apparent is that is just sticking to market capitalisation indices as benchmarks is likely to be misguided for a number of reasons.

MSCI recently announced the inclusion of Chinese A-shares in its indices, adding 222 shares to its Emerging Markets and ACWI benchmarks from June 2018. Longer term, if China continues to liberalise the A-shares market and MSCI is to fully include them, China’s weight in the MSCI Emerging Markets index could rise to 40.8% from 28%.

As the index provider says, institutional investors who have not examined how A-shares might fit into their portfolios should not underestimate the work involved in preparing, creating and maintaining such an allocation. Would A-shares inclusion alter emerging markets’ role in asset allocation? What is China’s role in emerging market equity allocation? MSCI also states that a sensible starting point would be to revisit the role of emerging markets in the policy asset allocation, including how China fits into that sub-asset class.

Investors considering EM equity investments have to first decide whether to adopt an active or a passive approach. The obvious attraction of passive investment is cost, but the problem with market-cap-weighted indices is that the better a stock does, the greater the weighting, so they have a pro-momentum and anti-value bias. In addition, investors sticking closely to cap-weighted market indices are getting little exposure to the grand themes driving EM growth – the increasing spending power of middle-income consumers and the favourable demographics of younger populations.

Alternative approaches such as fundamental indices conceptually get round this problem but end up introducing new issues of even more pronounced sector skews: two-thirds of the index universe is composed of financial, energy and basic materials companies, while one company (Petrobras) accounts for 9% of the total market cap. Petrobras is very volatile and subject to political interference, as are many other large companies such as Samsung.

Valuation dispersions are much higher in EM – and that means greater opportunities for active management. If investing in EM equities benefits from active management, then the logical conclusion is that investors should seriously consider investing in emerging market private equity. It represents a more active approach to investment than listed equities.

Accessing attractive but widely dispersed EM private equity opportunities is a challenge for investors – funds-of-funds provide one accessible solution.

Pension funds are still very wary of investing in EM private equity, but risks are misperceived and much lower than imagined. The opportunity set is very large. Until the 1800s, China and India represented more than 50% of global economic output and, by 2030, five of the 10 largest economies will be EM, according to the US Department of Agriculture.

Four key economic segments – food and agriculture, cities, energy and materials, and healthcare – could create a few hundred million new jobs by this point, and almost 90% of them would be in EM. The optionality value of such investing is high, while the opportunity costs are low.

At a time in which valuations of private equity investments in the US and Europe are very high, shifting to EM at much lower valuations does seem to make sense.

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