Morningstar Magazine - December 2017/January 2018 - 51

The Evolution of Emerging Markets
How to construct a portfolio in a
changing landscape.

INVESTMENT RESEARCH: EME RGING MARKETS

Ben Johnson

Emerging-markets stocks made up about 11.6%
of the global stock market (using the MSCI
All-Country World Index as a proxy) as of the end
of September. Thirty years ago, these stocks
represented less than 1% of the world's investable
equity market capitalization. These markets
are dynamic by definition. They have changed
dramatically in the past three decades,
and the pace of change has only accelerated
in recent years. Here, I'll look at emerging-markets
stocks' long- and short-term performance,
the most recent phase in their ongoing evolution,
how their makeup may evolve in the future,
and what this all might mean with respect to
portfolio construction.

cumulative performance peaked relative to
developed markets in October 2010 ( EXHIB IT 1 )
through the end of 2016, the MSCI Emerging
Markets Index fell 1.1% on an annualized basis,
while the MSCI World Index generated
annualized gains of 8.74%. But after almost seven
lean years, emerging-markets equities have
re-emerged in 2017. For the year to date through
September, the emerging-markets index increased
27.78%, while its developed-markets counterpart
rose 16.01%. Digging into the drivers of the
benchmark's year-to-date performance yields some
interesting insights into how its complexion has
changed in recent years.
Then and Now
E X H I BI T S 2 & 3 decompose the portfolio of
iShares MSCI Emerging Markets ETF EEM into its
constituent country and GICS sector exposures.

It is readily apparent that the composition of
this cohort has changed materially over the past
few years. From the point of view of country
membership, the most significant changes have
been the decline in Brazilian stocks' share
of the portfolio (from a peak of 16.9% in November
2009 to just 7.2% as of the end of August 2017)
and the increase in Chinese stocks' share
(which has risen to 28.9% from 15.5% during
this same span).
In terms of sector composition, there's been
an even more significant shift in the index.
In November 2009, energy and materials stocks
represented a combined 29.8% of EEM's
portfolio. As of the end of August, this figure had
declined to 14.1%. Back in 2009, technology
names accounted for 15.3% of EEM's portfolio;
by the end of August 2017, that figure had
increased to 26.9%.
Of course, this evolution is only natural. The
MSCI Emerging Markets Index is a broad,
market-cap-weighted benchmark. As such, it will
reflect the ebb and flow of firm-level fundamentals, investor sentiment, capital flows, and
so on across these markets. Thus, the shift in the
makeup of EEM's portfolio since its 2003
inception represents the net result of all the above,
as manifest in their relative performance.

Back in the Saddle

The MSCI Emerging Markets Index was launched
on Jan. 1, 2001. From its inception through the
end of September, the index's annualized return
amounted to 9.89%, versus 4.99% for its
developed-markets counterpart, the MSCI World
Index. Though these headline performance figures
are compelling, they belie the gut-wrenching
volatility that has characterized this span.
During this period, the emerging-markets index's
standard deviation of monthly returns and
maximum drawdown were 22.07% and 61.59%,
respectively. The comparable figures for the
MSCI World Index were 15.19% and 54.03%,
respectively. Emerging markets' path to greater
absolute returns has been a winding one.
Recent years have been particularly taxing
for investors in emerging-markets stocks.
From the time that the emerging-markets index's

EXHIBIT 1

Waxing and Waning The cumulative performance of emerging markets relative
to developed markets peaked in 2010.
Cumulative Return of the MSCI Emerging Markets Index Relative to the MSCI World Index
4.0%

3.0
2.149
2.0

1.0
0.0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Source: Morningstar. Data as of 09/30/2017.

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51


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Table of Contents for the Digital Edition of Morningstar Magazine - December 2017/January 2018

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