We believe that in the medium term, emerging markets (EM) are poised to outperform developed markets (DM), and EM small-caps are poised to outperform EM large caps. Our research shows emerging market equities outperformed developed markets most significantly when emerging economies are accelerating faster than developed economies. The global economy is entering just such a period, thus setting the stage for potential continued EM equity outperformance. We will show how EM small-cap equities could potentially offer higher returns with surprisingly lower volatility than the EM equities as a whole.
As the world faces greater pressure from deglobalization, we believe emerging markets growth will be increasingly driven by domestic demand. Compared to EM large caps, small-caps have nearly twice the exposure to domestic sectors such as health care and consumer discretionary, which we believe are particularly well positioned as emerging economies move away from exported growth models.
Why We Are Positive on EM vs. DM: EM equities have outperformed DMs most significantly when emerging economies accelerated faster than developed ones,1 and the global economy is entering just such a period. The relative performance of EM is best explained by the GDP growth differential—specifically the difference between the EM aggregate real GDP growth rate and the DM aggregate. This differential troughed in 2015 after five years of decelerating growth in emerging economies, and emerging stock markets materially underperformed DM during this period.2
Now, a shift is underway. We expect EM growth to accelerate from 4.1 percent last year to 4.8 percent in 2017, while DM growth picks up more slowly from 1.6 to 2 percent.3 This widening growth gap is a big reason why EM equities have outperformed DM equities over the past year, and we believe the gap could continue to widen.4
Why We Are Positive on EM Small-Cap: Although many institutional investors have adopted an all-cap universe in an effort to remove country and market-cap bias, the all-cap indexes are in fact dominated by large companies. For example, 86 percent of the companies listed on the popular MSCI EM Investable Market Index (IMI) are large or mid caps.5 Investors who adopt these all-cap indexes are unintentionally betting on large and mid caps against small-caps. And these bets can be substantial, as all-cap investors are estimated to be between 10 to 20 percentage points underweight for EM small-caps.6
While this accidental underweight might have worked the last few years, it could potentially hurt over the long term as small-caps have offered better longer term returns within EM. Small-caps have outperformed the MSCI EM Index by an annualized 2.6 percent since the global financial crisis in December 2008 (see Display 1). While it sounds counterintuitive, EM small-caps have delivered this outperformance with around one percentage point lower volatility than EM. Why is volatility so much lower? It is primarily a function of lower liquidity in small-caps, and less institutional investment, specifically, hedge fund activity in these markets.
Performance indexed to 100, January 1, 2009 through July 31, 2017
Why You Need a Dedicated EM Small-Cap Manager: While some investors choose all-cap EM managers, the increase in assets under management (AUM) of many of these managers has made it difficult for them to buy enough small-cap stocks to maintain even a neutral small-cap exposure versus the index. Since 2007, all-cap EM managers have seen their average market cap grow from $38 billion to $58 billion, and their average product AUM grow from $5.4 billion to $6.5 billion.
Because of the systematic if unintended biases inherent in the way many investors allocate assets, EM small-cap is a widely ignored asset class. This inefficiency is compounded by a lack of information as few sell-side analysts cover the space. This makes EM small-caps an area where active management thrives. Over the 3-year period (based on median active manager excess returns), an EM small-cap manager generated over 1.5 percent more excess returns than an EM all cap manager (Display 2). This outperformance is even more impressive on a 10-year period with 3.2 percent more excess returns.
Based on Median Active Manager Excess Returns (Annualized)
Why You Need an Integrated Top-Down Approach Focused on Quality Stock Selection: Our research shows that EM equity returns are greatest when managers invest in countries with high or accelerating GDP growth. Similarly, MSCI Barra has found that the country effect drives nearly 60 percent of risk in EM, as opposed to approximately 30 percent in Developed Markets. Divergences in country returns have increased since the global slowdown, making it increasingly vital to focus on individual country and currency factors as part of the investment process. This is especially true in EM Small-Caps, since these companies tend to be more domestically driven.
Equally important to generating excess returns is a robust bottom-up stock selection framework focused on company quality. Over the past 5 years, quality companies with double digit ROE and low debt levels returned 14 percent versus the low quality companies which returned -4 percent.
Please consider the investment objectives, risks, charges and expenses of the funds carefully before investing. The prospectuses contain this and other information about the funds. To obtain a prospectus please download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.