The aggregate free-float market capitalisation of the MSCI Emerging Markets (EM) Index and the MSCI Pacific ex Japan Index stood at US$7.3 trillion ($10 trillion) and represented a 15.4% weight of the MSCI ACWI Index, as of June 30, compared with US$1.8 trillion and an 8.5% weight at the end of 2004. The rise of market size in both absolute and relative terms reflects, in part, increased business productivity and dynamism in the EM and Asia, as well as expectations of the regions’ potential for future economic and financial-market growth.
The period was also marked by the growth of regional-focused active strategies. During the 15-year period from 2004 to 2019, the aggregate assets of active EM and Asia regional funds tracked by the Thomson Reuters Eikon mutual-fund database grew at a 10.4% annualised rate, whereas the aggregate size of active EM and Asia single-market-focused funds grew at a 7.7% annualised rate.
The growth was supported, in part, by active managers’ ability to generate higher alpha in EM compared to the developed markets (DM) over the same period, as well as the build-up of an EM derivatives ecosystem that extended the scope and flexibility of regional-based strategies.
The importance of market differences within EM and Asia
The EM and Asia market is not a homogenous equity segment. To illustrate this, we break down EM and Asia into four subregions — Pacific, EM Asia, EM Europe, the Middle East and Africa (EMEA), and EM Latin America — and look at annual returns. During the past decade, our research shows annual return dispersion between the best- and worst-performing sub-regions exceeded 30% at times.
At the country level, the annual return dispersion of the best and worst performers reached as high as 70% at times, among the countries covered by the MSCI Emerging Markets Index.
Given this wide dispersion of country-index returns, how did countries as a factor group explain individual stock performance over the period? Chart 1 below shows that the country factors explained 40% to 80% of the systematic cross-sectional volatility (CSV) of the MSCI AC Asia Pacific Index from December 2004 to June — higher than the respective contributions from sectors and style factors.
How some investors used regional and single-country index futures
Given the dynamic performance rotation and dispersion across the sub-regions and countries of EM and Asia, some investors looked beyond traditional long-only approaches, including futures. Some have employed:
1. Directional strategies: Investors long or short a contract, or a basket of contracts for a certain time horizon. For example, investors may gain exposure to an MSCI Japan Index futures contract to reflect their views on short-term dislocation of the Japanese market, or they may use a combination of
MSCI Pacific ex-Japan and MSCI China Free contracts to match exposure to a developed Asia-plus-China portfolio.
2. Relative strategies: Investors match long position(s) with short position(s) within index futures to reflect their views on potential relative mispricing and market-dislocation opportunities. For example, an investor can combine index-level fundamental data, such as price-to-forward-earnings ratio, to decide on tactical positioning.
3. Macro-rotational strategies: Investors use more complex country long/short strategies based on macroeconomic analysis, bottom-up fundamental analysis and quantitative signals. Chart 2 illustrates an example where an investor combined index-level price-to-forward-earnings ratio and three-month risk-adjusted momentum to rotate between long and short positions in a basket of EM and Asia single-market indexes.
In conclusion, investors may look to the above approaches as well as others, to enhance an existing investment process or potentially expand the scope of regional return sources.
With contributions from Shuo Xu, Wei Xu and Naoya Nishimura
