Joseph Mariathasan is surprised by the lack of debate over how best to gain GEM exposure

Few would disagree with the statement that emerging markets are too large and important to ignore for any institutional investor. Yet what is surprising is the lack of debate over how best to gain exposure to the future driving forces behind their growth beyond commodity exports. Should they be seen as a tactical play? Or should they be seen as an integral and perhaps even the major component of long-term portfolios?

We are witnessing a historic shift as the emerging and frontier markets as a whole evolve into economic powers rivalling the developed markets during this century. That shift in power lies behind much of the tensions seen within developed markets. US president elect Donald Trump’s moves to rein back outsourcing manufacturing to emerging markets is just one manifestation of that. Yet, 400 years ago, living standards in China and India were arguably higher than in Europe. There is no a priori reason why developed markets should continue to maintain higher living standards than many of the developing. Indeed, Beijing is now a First-World city, with the infrastructure and pollution to prove it.

Yet while the importance of emerging markets may be accepted in theory, in practice, allocations have become less than optimal. Invariably, investments tend to be couched in a framework based on market-capitalisation-weighted indices, which are leading to increasingly concentrated exposures. The high volatility associated with emerging market equities is, to large measure, a result of the concentration of countries (seven) and sectors (export-orientated) in the MSCI EM. Yet, with different approaches to investment in emerging markets, it should be able to produce less volatile allocations, which are paramount to the preservation of capital.

What will soon provide a catalyst to the debate will be the impact of the huge weighting China will have on the MSCI index and the problems that will bring. One solution would be to take China and possibly India out and start looking at them in isolation. But perhaps investors seeking exposure to emerging markets should move away altogether from GEM equity benchmarks and decide what exactly exposure to emerging markets could and should represent. There are far more opportunities in emerging markets than the universe represented by GEM ETFs. What is also worth considering is that it should also be possible to produce portfolios that are less volatile.

A key problem with the flows into GEM ETFs is that the major indices themselves – while logical from a consistency viewpoint, with a market-capitalisation-weighting scheme – also look nonsensical from other viewpoints. The big downside of GEM fund strategies, particularly with benchmark-constrained approaches, is that there will be a tendency to concentrate exposure in larger companies and larger countries. The BRICs, together with Korea, Taiwan and South Africa, dominate most traditional GEM institutional portfolios, yet this leaves a large part of the opportunity set untapped.

But if that is the case, are investors really getting exposure to what is perceived as the great tidal wave driving the growth of global GDP, the rise of the emerging-market consumer? One fundamental point often missed is that listed equities in many emerging markets can account for a much smaller proportion of the economies than found in developed markets. Adopting a market-cap-weighted approach to benchmarks does not reflect the relative size of economies and focuses on larger companies that have historically been more export and commodity orientated.

Moreover, in many markets, many of the listed stocks are so small and illiquid it makes little sense to differentiate them from private equity investments, with private equity firms in India, for example, including listed stocks in some cases into their portfolios, along with all the trappings of private equity investment, such as board representation and value-added advice.

Emerging markets are the elephant in the room for any investor. But deciding how best to ride that elephant requires more thought than merely hopping onto the nearest market-cap-weighted global EM index fund.

Joseph Mariathasan is a contributing editor at IPE

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