Emerging market (EM) equities currently comprise 11% of free float, all-country market capitalization, so it is no surprise that many investors include EM as part of their long-term asset allocation. Japanese investors maybe considering adding emerging market (EM) equities to their portfolios. What type of baseline EM exposure might be most suitable for Japanese investors? Given recent improvements in benchmark technology, more extensive data coverage, and empirical research in the underlying drivers of equity returns, Japanese investors can consider selecting, or designing, an EM benchmark that is most advantageous.
PGIM IAS shows that a traditional market-capitalization EM benchmark (e.g., MSCI EM Index) may not be best-suited. For example, the MSCI EM Index has more than 50% of its market value represented by just three countries: China, Korea and Taiwan. After the United States, these three neighboring countries are the largest export destinations for Japan. In addition, almost 50% of the traditional EM benchmark is represented by exposure to just two sectors: Financials and Technology. These two sectors are also heavily represented in developed equity markets, with more than a 30% combined weight.
Based on recent research showing that EM returns are influenced by sector and style exposures, in addition to country exposures, they propose “country-based”, “sector-based” or “style-based” alternative EM benchmarks which may be better suited to a Japanese investor’s circumstances. When constructing these benchmarks, they also use alternative weighting schemes – ERC and equal-weight. There are many other potential exposure weighting schemes, and some may work better than others depending on the economic regime. These three alternative EM benchmarks have provided better diversification, risk-adjusted returns and lower performance drawdowns for Japanese investors, compared to a traditional EM benchmark. Japanese investors should consider adopting one of these alternative EM benchmarks to represent their baseline EM allocation.