Should an SA investor still consider emerging markets?

Diversification benefit

South African investors often ask whether it makes sense to have exposure to global emerging markets in their portfolios. One reason is that the South African market is highly correlated with emerging markets, given that South Africa itself is an emerging market. The data shows that the South African market has an average correlation of 80% to the MSCI Emerging Markets Index over various periods from one year to 10 years. Surprisingly, this is only marginally higher than the 70% correlation of the South African market to the MSCI World Index.

Chart 1 below compares the sector exposure of the MSCI Emerging Markets Index with the FTSE/JSE Capped SWIX Index, highlighting key differences. Investors in South Africa have limited opportunity to buy growth and technology-focused sectors, while being more exposed to cyclical and capital-intensive industries like financials and materials. The MSCI Emerging Markets Index composition, on both country and sector basis, has changed significantly over the last fifteen years. It is noteworthy that the MSCI Emerging Markets Index now offers more growth and technology exposure than MSCI World Index. In terms of cyclical exposure, it is similar to having more Financials but fewer Industrials.

Diversification benefit

The opportunity set and diversification benefit provided by emerging markets should thus not be underestimated. Even though South African investors have similar exposure to the e-commerce sector at an index level, this hides the diversification benefit that emerging markets could provide. Using the e-commerce sector as an example, South African investors only have Prosus and its holding company, Naspers, as investable opportunities in the theme. In contrast, investors in emerging markets can diversify the stock-specific risk and keep a similar exposure to the theme through businesses like Pinduoduo, Alibaba and JD.com.

Emerging markets further give investors access to their own fast-growing, quality businesses within the information technology sector, with Taiwan Semiconductors being a prime example, whereas there are no such options available in the South African market. The significantly broader opportunity set in emerging markets allows investors to find and own businesses still in the early stages of development—many of which have drawn inspiration from global peers like Amazon and other fintech companies and replicated their business models in local markets.

Volatility brings opportunity

On a country level, emerging markets are very attractive to active fund managers and are a fertile ground for alpha generation. This is due to the significant divergence in performance of the different countries within the Index in any given year.

It is common for countries to have more than 40% differences in dollar returns in any given year. Using 2024 as an example, we can see that China increased by around 20%, while Brazil and South Korea decreased by more than 20%. This creates attractive opportunities for active managers to recycle capital from countries and sectors that have done well into countries that have underperformed.

Graph 2 below illustrates this point by plotting the US dollar returns of a few selected countries as individual dots per year and the return of the Emerging Markets Index as a line over the periods.

Graph 2: Total USD returns per annum in key emerging markets

Higher economic growth exposure

Furthermore, the exposure that emerging markets provide to high-growth countries like China, India and Kazakhstan is very attractive. Chart 3 below shows South Africa has only been able to grow its GDP per capita by 0.7% per annum over the 20-year period, whereas a country like China has been able to grow GDP per capita by 7.6% per annum and India by 5% per annum. The runway for continued growth also remains attractive, with China’s GDP per capita currently only 29%, while that of the United States and India is around 12%.

We know that over time, the value of an investment is driven by the earnings power and free cash flow generation of the business. It is easier for companies to grow in a healthy economy. Moreover, corporate governance continues to improve in emerging markets, and management teams are increasingly focused on driving shareholder returns, with Korea’s value-up programme and China’s 9-plan rule being two recent examples.

Graph 3: GDP per capita

Closing thoughts

In conclusion, emerging markets are an attractive building block in a portfolio for South African investors given the much wider opportunity set of quality, fast-growing businesses and diversification benefits on a stock, sector and country basis. The scatter plot highlights that active managers have ample opportunities to rotate between regions, given the divergence in performance, thereby adding additional alpha to the portfolio.