Investors have historically favored emerging markets for their high growth potential, relative inefficiency, and diversification benefits due to their low correlations with developed markets. While timing asset class allocations is notoriously difficult, we believe now is a good entry point for long-term investors to consider increasing their active allocations to emerging markets.

Our current view of emerging markets is anchored in the following key pillars:

• Historic valuation dispersion: Emerging markets have consistently traded at a discount to developed markets; however, the historical valuation differential is now at its widest level since the dot-com bubble.
• Future growth expectations: Buoyed by favorable demographics and a growing middle class, emerging markets' contribution to global economic growth will continue to rise. Improvements in corporate governance will help translate GDP growth into corporate earnings growth.
• Mispricing opportunities: Given their more complex market dynamics and inefficiencies, emerging markets present active investors the potential to uncover significant value to help reach their investment goals.

Historic Valuation Dispersion

During the nearly 40-year period starting in 1987, the performance differential between emerging and developed markets has occurred in long, multi-year cycles (Figure 1). Since that time, there have been four super cycles of performance differential, with the average duration lasting about nine years. The current cycle of underperformance for emerging markets has lasted 13 years, notably longer than the historical average, as seen below.

Playing the mean reversion game is challenging, however, as cycles often persist longer than anticipated. In conjunction with mean reversion, we also consider historical relative valuations to understand when the mispricing is at its widest. Figure 2 illustrates the valuation spread between emerging and developed markets over time. Notably, the Y-axis shows that while emerging markets have consistently traded at a valuation discount to developed markets over the past 25 years, this discount is currently approaching one standard deviation, a level not seen since the dot-com era.

To provide further context around the potential value opportunity in emerging markets, we analyzed the normalized valuation spread relative to the forward five-year return differential since 1999. When the normalized value spread is less than -0.5, the forward five-year return of emerging compared to developed markets is 12%. As of July 24, 2024, the spread was -0.5, suggesting a favorable time to lean in to emerging markets based on valuation.

Future Growth Expectations

Emerging markets have historically outpaced developed markets in real GDP growth, a trend we believe will continue and likely strengthen. These countries have larger working-age populations (15-64) compared to developed nations, a gap the IMF projects will only widen. This demographic advantage, coupled with robust GDP growth, is fueling the rise of an expanding middle class poised to become the global consumers of tomorrow. Additionally, meaningfully lower debt-to-GDP ratios of many emerging market countries translate to healthier national balance sheets than seen in their developed counterparts. Given these tailwinds, why have emerging markets trailed developed over the past decade?

Despite historically higher GDP growth, corporate earnings growth in emerging markets has lagged. For most of the last 12 years, year-over-year corporate earnings growth in emerging markets has consistently trailed that of the US, driven in large part by weaker corporate governance, poor capital discipline, and deficient shareholder protections. However, the earnings drought in emerging markets appears to have bottomed out, with company fundamentals beginning to strengthen. This turnaround can be attributed to recent improvements in corporate governance and financial reforms that focus on greater capital discipline, enhanced shareholder value, investor protections, and information disclosure and transparency.

Opportunities for Active Managers

In general, passive mandates have performed extremely well over the last 20 years net of fees. However, emerging markets may be an area ripe for active investors to find value not readily available in the developed world given the more complex market dynamics, unique risks, and rich mispricing opportunities.

Emerging markets have unique properties that make them more inefficient than developed markets. It starts with lower global investor attention, leading to fewer analyst opinions and greater mispricing. Unlike in developed, liquid markets, this mispricing is not arbitraged away as rapidly. Limited attention stems from the fact that emerging market companies have historically offered lower transparency, limited disclosures, and less favorable shareholder protections. Furthermore, information in these markets tends to be less uniform and reliable, making the process of collecting, cleaning and interpreting the data particularly important - yet challenging - which can deter many investors.

Given these limitations, one might expect a smaller opportunity set of high-quality companies to invest in. However, there are more than 3,400 investible stocks across 11 sectors and 24 developing countries. This diverse universe, combined with less reliable information, underscores the importance of risk management and creates compelling opportunities for active investors. This is borne out in the data; over the past decade, cross-sectional stock return dispersion across the US, EAFE, and EM shows that not only is the average return dispersion higher in emerging markets, but the range of outcomes significantly outpaces developed markets as well.

Emerging market active managers have consistently demonstrated their expertise by leveraging informational advantages, mitigating higher transaction costs, and navigating the pronounced sector concentration risk within emerging markets. Quantitative managers in these markets hold an additional edge given their historical focus on risk management, construction of well-diversified portfolios that incorporate transactions costs in decision-making, and ability to successfully evaluate thousands of stocks simultaneously. For allocators considering increased exposure to emerging markets, active management offers a dual advantage - it can enhance returns while effectively managing risks.