March 11, 2025
Emerging markets equities can offer outsized potential and portfolio diversification benefits to investors for three reasons.
First, emerging markets tend to exhibit a substantial demographic advantage over developed markets due to their youthful populations and increasing urbanization rates. These dynamics have the potential to drive faster economic growth in emerging economies. Companies in emerging markets may be better positioned than in the past to capture this economic growth and create value for investors.
Second, emerging markets equities can also serve as an important diversification tool within investor portfolios because of emerging markets' unique economic market cycles and moderate correlation with developed markets.
Third, the greater number of inefficiencies in these markets can create a landscape ripe for alpha generation.
Economic growth drivers: Demographics and urbanization
The International Monetary Fund estimates that emerging and developing economies will grow at 3.9% per year over the next five years, more than double the anticipated 1.7% growth rate for advanced economies.
Emerging economies are expected to grow faster than advanced economies
Source: International Monetary Fund (IMF) World Economic Outlook, April 2024.
We believe a more favorable demographic profile is a key driver of developing economies’ higher structural growth, particularly in markets outside China. As recently as 2022, the proportion of the population under 40 years old was approximately 66% in developing economies, and 71% if China is excluded, compared with 47% in developed economies, according to United Nations Trade and Development (UNCTAD). Due to younger demographics and higher birth rates, the population of developing economies is expected to grow at a 0.8% rate through 2050, compared with flat growth in developed economies. This “demographic dividend” implies that a larger workforce can support economic growth and higher consumption.
Population is growing in developing economies
Source: United Nations Trade and Development, Handbook of Statistics 2023.
Rising urbanization rates also contribute to economic growth in developing economies because access to infrastructure and services increases productivity levels. According to UNCTAD, urbanization rates in developing economies are 52% as of 2022 (versus ~80% in developed economies) but are expected to increase to 65% by 2050.
People in developing economies are moving to cities
Source: United Nations Trade and Development, Handbook of Statistics 2023.
Growth and value creation
Though emerging (and developing) markets have generally grown faster than developed markets, investors have rightly pointed out the challenges that weigh on the ability of investors in emerging market companies to fully benefit from that growth. These challenges include the following:
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Government policies have sometimes encouraged excessive fixed-asset investment, leading to overcapacity and thus lowering returns on capital.
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Corporate governance has often placed a lower relative priority on transparency and minority rights.
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Economic growth has often been concentrated in industries lower in the value chain, where valuation multiples are typically smaller.
We see numerous, evolving reasons to be optimistic about the potential ability of emerging market companies to generate value for shareholders.
First, the higher interest rate environment has made companies more cautious about deploying capital in lower return projects and potentially improving competitive dynamics.
Second, in places like South Korea, we are observing increased scrutiny on corporate governance practices from large domestic institutional investors and government policymakers.
Third, in multiple industries, emerging market companies have begun to establish higher positions on the value curve. For example, in the leading-edge semiconductor space, we find emerging market companies’ technological capabilities to be on par with, if not exceeding, those of their developed market counterparts. In certain consumer sectors, emerging market companies are gaining market share from developed market competitors by narrowing the perceived quality gap and innovating in differentiated ways that better target local tastes and trends.
Portfolio diversification
Emerging markets equities can also offer diversification benefits to investor portfolios concentrated in US and developed markets equities due to historically lower correlations and non-concurrent economic and market cycles.
Emerging markets equities can offer diversification benefits
Source: Bloomberg. Emerging markets represented by MSCI Emerging Markets Index; US represented by S&P 500 Index; developed international represented by MSCI EAFE Index.
This diversification benefit has the potential to grow as emerging economies become increasingly important, independent parts of the world economy. The continued emergence of a large and growing middle class in emerging economies has created a powerful source of domestic demand in many countries. Trade and capital flows between emerging economies have increased substantially as global supply chains have continued to reconfigure.
Alpha generation opportunity
In addition to contributing to portfolio diversification, emerging markets equities may offer an appealing universe for active managers to generate alpha. These markets typically have less analyst and news coverage and have lower institutional investor participation than developed markets. These factors may contribute to lower overall market efficiency and could increase the opportunities for active managers to generate excess returns.
Quantitative analysis seems to support this thesis. The amount of variation in performance and price movement between emerging market stocks over the past 20 years has been notably higher than that of US or developed market stocks, suggesting opportunity for stock selection in emerging markets. Historical performance of active fund managers offers an additional perspective. An analysis of active managers that invest in emerging markets or developed markets equities shows that a higher proportion of emerging markets equity managers have been able to beat their benchmarks over time.
Emerging markets equity managers can outperform
Source: Morningstar. Emerging markets equity represented by Morningstar Diversified Emerging Markets Category (140 funds); US large-cap equity represented by Morningstar Large Blend Category (248 funds); foreign large-cap equity represented by Morningstar Foreign Large Blend Category (136 funds).
Opportunity in emerging markets equity
We believe emerging markets equities offer a compelling blend of opportunities for investors. Economic growth premiums in emerging markets continue to be supported by structural factors, and evolving conditions potentially support more value to accrue to equity investors. Meanwhile, the distinct characteristics of emerging markets equities as an asset class offer investors the ability to benefit from diversification and potential excess returns generated by active management.
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
International investments entail risks including fluctuation in currency values, differences in accounting principles, or economic or political instability. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility, lower trading volume, and higher risk of market closures. In many emerging markets, there is substantially less publicly available information and the available information may be incomplete or misleading. Legal claims are generally more difficult to pursue.
Investments in small and/or medium-sized companies typically exhibit greater risk and higher volatility than larger, more established companies.
Natural or environmental disasters, such as earthquakes, fires, floods, hurricanes, tsunamis, and other severe weather-related phenomena generally, and widespread disease, including pandemics and epidemics, have been and can be highly disruptive to economies and markets, adversely impacting individual companies, sectors, industries, markets, currencies, interest and inflation rates, credit ratings, investor sentiment, and other factors affecting the value of the Fund’s investments. Given the increasing interdependence among global economies and markets, conditions in one country, market, or region are increasingly likely to adversely affect markets, issuers, and/or foreign exchange rates in other countries. These disruptions could prevent the Fund from executing advantageous investment decisions in a timely manner and could negatively impact the Fund’s ability to achieve its investment objective. Any such event(s) could have a significant adverse impact on the value and risk profile of the Fund.
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