The emerging markets (“EM”) equity asset class has evolved considerably over the past decade such that many active EM equity managers may find it challenging to create long-term alpha over the benchmark. Countries such as China and India are moving to the fore, historical drivers of growth are changing and technology, innovation and health care are becoming a larger part of the opportunity set. It has been difficult for EM investment teams to keep up with these changes.

The good news is that investors can adapt their EM allocations through a thoughtful combination of strategies to enhance opportunities for long-term outperformance. The thesis for outperformance is fairly straightforward—combine exposures such that you address the largest weight biases, current shortcomings and forward-looking attributes of the MSCI Emerging Markets Index. What does that mean specifically?

The way I see it, there are six primary issues to address when creating exposure best suited to generating long-term outperformance. The first three issues address what we feel are internal weighting biases of the benchmark and the second three issues target the benchmark's possible shortcomings. All six issues are potential sources of alpha.

  1. Address the elephant in the room by getting the Asia component right
  2. Build a better value portfolio to address the benchmark's bias toward low quality
  3. Acknowledge the benchmark's increased technology bias
  4. Understand the benchmark's underweight to small-cap stocks
  5. Overcome slowing growth among more developed countries in the benchmark with exposure to faster-growing economies
  6. Add exposure to consumer-driven sectors to address the benchmark's cyclicality and volatility

1. Address the elephant in the room by getting the Asia component right

Benchmark weighting bias: Asia is now 73% of the EM benchmark.

To succeed in EM, you need deep expertise in the benchmark's largest weights. Specifically, the “Big Three”—China, South Korea and India—which alone account for nearly 54% of the benchmark. An investor's biggest challenge is to find a team that has the research wherewithal to handle the China and India of tomorrow. A difficult task indeed. The universe of accessible Chinese names has more than doubled from approximately 2,700 Hong Kong and U.S.-listed Chinese companies to roughly 6,400 names, including China's locally listed companies in Shanghai and Shenzhen, as of September 30, 2018. Over 80% of these new names are small- and mid-cap stocks, a significant portion of which are not covered by analysts at present. Some have world class management teams and economic moats, while others are deficient in corporate governance and minority shareholder treatment. The point here is that most active EM investment teams just do not have the research bandwidth to handle China's expansive equity universe. For perspective, at Matthews Asia, we have 19 Mandarin speakers on our investment team and even we find it challenging to get our arms around the opportunities and risks in today's China. India will become similarly complicated as the broad Indian stock market has more than 5,000 names, over 80% of which are small caps—which creates opportunity no doubt—but also requires a level of research depth and scope that many investment teams may lack.