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Beating Frustration in the Emerging Markets

Authored by Sudhir Roc-Sennett, Head of Thought Leadership & ESG, Quality Growth Boutique, Vontobel Asset Management. Originally published as a Turning Stones blog on the Vontobel website, this version includes information on the role of governance in the Virtus Vontobel Emerging Markets Opportunities Fund, including ESG quality ratings of the companies in the portfolio.

In volatile times, investing feels like a sprint, but it’s still the same long-haul marathon. Nowhere does setting the pace right matter more than in the emerging markets (EM). EM swings can be extremely frustrating. Valuations unhook from underlying value around worst-case scenarios with regularity. It’s no wonder there’s a temptation to give up on the long term and take a short cut – perhaps buy something less volatile, like Chinese equities or low yield bonds.

What’s important to remember, though, is that lower volatility for long-term holders does not mean lower risk. The emerging markets have been through many challenges – epidemics, political scandals, riots, inflation, deficits, oil collapses and surges, and natural disasters. They adapt, and grow.

Yet, over the last decade, passive holders of the MSCI Emerging Markets Index have received a 1.5% average annual return over 10 years in U.S. dollar terms1 – a meager return for such a strong story. Many active managers have done better, as they should.

Here’s our view on why the EM remains an attractive place to be, in good times and bad, and even as Covid-19 uncertainty continues to grip the world.

The 26 countries that MSCI defines as emerging markets2 are not generally weak economies. They may be volatile, but the core EM markets have choices, and do not face the constraints more often found in lesser-developed “frontier” markets. Combined, these 26 markets represent massive geographies where supply and demand dynamics play out just as much as they do in developed markets, but with some 4.5 billion people, roughly 60% of humanity. These markets present considerable opportunity, but it is not evenly distributed.

The simple reality is that the EM offer huge growth potential, with risks scattered throughout. Opportunity is considerable but is not evenly spread. It is concentrated in pockets. After researching a quality EM business with good economics, much of the remaining risk stems from the “dark art” of corporate governance. There is no magic, a risk is a risk. Growth and staying ahead of governance issues are both vital to compound value. The chart below shows performance of MSCI EM companies relative to their ESG ratings over the last five years.

Stronger ESG-Rated Companies Have Outperformed MSCI EM Index 5-Year Performance by ESG Quality

Source: MSCI ESG, FactSet. Performance of annualized total returns in U.S. dollars, 4/30/2015-4/30/2020. ESG quality as measured by MSCI ESG ratings: Strong: A, AA, AAA; Decent: BBB; Cross Over: BB; Weak: B, CCC. Past performance is no guarantee of future results.

In light of current volatility, there are two questions EM investors may be asking:

  1. What EM playbook can deliver reasonable returns without significant risk?
  2. Would piling into China lower the risk of an EM investment?

EM Playbook

The EM playbook, as we see it, is based on three simple yet critical concepts: establish a return and risk balance, find growth, and guard the investment from trouble.

1. Return/Risk Balance – An investor in lower-risk, high-quality businesses should consider a long-term dollar return in the 8 to 12% range as achievable. More than that, experience has taught us that risk seems to rise exponentially alongside small stretches in return goals – so discipline is important.

2. Find Growth – Growth is supported by the rising tide of demand as hundreds of millions of people grasp a better quality of life, providing demand for innovative and well-run companies with enduring brands. Over the course of 25 years, traditional dominant EM companies in energy, materials, and utilities have been replaced by a new generation of knowledge economy and consumer-facing leaders.

Areas where quality growth companies can be found include:

Domestic Market Leaders – These unique markets offer opportunities for savvy local players to take share from inefficient state players. Example: Indian retail bank HDFC Bank. There is also a greater tolerance of high market share in many emerging markets. Oligopolies can deliver benefits to multiple stakeholders, including governments, if they share common goals and remain competitive. Examples: Chinese internet companies Alibaba and Tencent. Also in this group are listed EM subsidiaries of multinationals that are often well-governed and benefit from the product portfolios and purchasing power of their parents.

Dominant Regional Leaders – A relatively small subset of firms that have successfully expanded beyond their home market to become regional leaders. Examples: Latin American retailers Wal-Mart de Mexico and Femsa (convenience stores), and Asian insurance giant AIA.

Global Leaders – Advanced EM-based global leaders generating diversified revenues streams from across the globe. Examples: Semiconductor giants TSMC (Taiwan), Samsung Electronics (Korea), SK Hynix (Korea), and Indian IT services giants TCS, Infosys, and HCL.

DM Transformed to EM – A number of developed market (DM) companies now generate more than half of their business from the EM. Generally, this is the result of successful targeted growth or acquisitions of large local franchises. Examples: Brewers AB Inbev (Belgium) and Heineken (The Netherlands), and HSBC (UK).

3. Guard the growth – While opportunity in the EM comes in many forms, there is a concentration of risks around the governance of companies where minority shareholders are generally in weaker positions than they are in developed markets. To give an idea of EM governance in relative terms, the chart below shows the distribution of MSCI ESG company ratings across the MSCI benchmarks for China, EM, and the All Country World Index (ACWI). More than a third (36%) of the companies in the ACWI are rated A or higher (highest ratings), compared to 16% in the MSCI EM, and just 5% in the MSCI China. China skews to the low end with 58% of its companies rated the lowest, B or CCC. 

MSCI ESG Rating Distribution by Number of Companies

Source: MSCI ESG, FactSet.

Governance problems are often rooted in who controls the business. The main “controlled” business types are state-owned enterprises (SOEs) and family businesses. In controlled businesses, minority shareholders have less, or in many cases, effectively no control. The MSCI China has 85% of its weight in controlled companies.

Business Ownership Type by Weight (as of 3/31/2020)

Source: MSCI ESG, FactSet. Controlled businesses: largest shareholder/group has 30%+ voting rights. Principal: largest shareholder/group holds 10-30% of voting rights. Widely held: no shareholder/group holds above 10% of voting rights.

Governance issues with SOEs start with the alignment of interests between government, politicians, and minority shareholders. A challenge for long-term investors is that government decision makers, and priorities, can change with little notice. The issues around family businesses are different. The financial goals are usually more closely aligned, but challenges often arise related to decisions about capital allocation (acquisitions), executive selection (family versus professional), and accountability. It’s important for investors in controlled businesses to remain vigilant and react if they sense trouble.

Better off in China?

Throughout the pandemic, China has conveyed a picture of discomfort but also stability on a seemingly sure economic footing. It was ground zero for the virus, but seems to be one of the first countries to come out from it as well. China’s currency is stable, supported by a closed capital account that is keeping savings in the country. It is the workshop exporter of the world and its domestic economy seems to grow like Jack’s beanstalk. Sure, it’s got lots of debt, but if it never goes bust, what’s the problem? Does it make sense for investors to weather the storm in China, and venture back out into other emerging markets when it’s cleared up?

It would be great to have a serene EM island of growth and stability. Unfortunately, it’s not that simple. China is a big part of the MSCI EM Index and investable choices appear narrow. With China making up 41% of the benchmark, very few would suggest that overweighting China will bring diversification. For a sense of how big China has become, consider this: it now has two companies in the Index with individual weights greater than Brazil.

Country vs. Company Weights – MSCI EM Index (as of 4/30/2020)

Source: FactSet. Largest countries and companies by weight within the MSCI EM Index.

To cover quality hurdles such as earnings predictability and governance, it’s tough to find conviction in large chunks of the Chinese market. This is normal in any market. Few businesses offer long-term growth with decent predictability, and it is no different in China. But with such a large market in the index, and such a narrow selection, you need to watch for risk accumulation.

Geopolitical pressure is building against China at the same time its long bull run has left households and companies highly levered. Barring a major blow-up with the U.S., there are Chinese companies that should have the structural growth and strength to manage fine through a recession. The challenges for stock pickers are visibility in terms of governance and understanding the goals of the regulators, which are an important part of company analysis in China.

The chart below takes a look at governance through ESG scores (by sector) of the MSCI China. We lumped the ratings into several groups: A-and-above as strong, BBB as decent, BB in crossover territory, and B and CCC as weak. The strong/decent groups account for just 17% of the companies. The IT sector has the most with 21 companies. Without visibility, good or a mirage, there is no way to differentiate a company’s resilience if we cannot see the sustainable dynamics driving the business.

ESG Scores for MSCI China (by Sector)

Source: MSCI ESG, FactSet. Data as of 3/31/2020.

Case in Point: Managing Risk through Higher ESG-Rated Businesses

At Vontobel, ESG is a critical part of our long-term investment philosophy, and ESG analysis is implemented at the stock level within our portfolios. In our view, ESG issues have an important influence on a company’s forecast growth and stability, and are integral to its long-term earnings potential. At the same time, risks stemming from poor management choices have the potential to damage long-term returns for investors.

Specific to the Virtus Vontobel Emerging Markets Opportunities Fund, the Fund’s exposure to China is tilted toward businesses with higher ESG ratings than those in the MSCI China Index, as illustrated below.

ESG Ratings Distribution: China holdings within the Virtus Vontobel Emerging Markets Opportunities Fund vs. MSCI China Index (as of 4/30/2020)

Cash is excluded. Source: FactSet, MSCI ESG Research.

Companies with higher ESG ratings can be found throughout emerging markets outside of China. As shown in the chart below, the ESG ratings of the holdings in the EM Opportunities Fund are notably higher on average than those of the MSCI China Index.

ESG Ratings Distribution: Virtus Vontobel EM Opportunities Fund vs. MSCI China Index (as of 4/30/2020)

Cash is excluded. Source: FactSet, MSCI ESG Research.


We continue to see a strong case that high quality businesses across the EM can provide multi-decade growth with diversified return drivers. For investors who find the investment opportunities, an important element that guards compounding from trouble is to focus on governance. Of particular importance is the alignment of interests with controlling shareholders such as state-owned and family-controlled companies. Along these lines, China presents its own set of quality hurdles for stock pickers relative to earnings predictability and governance. The challenge, of course, is putting up with the volatility during downturns. Low volatility is not the same as low risk, and that’s important to remember on the long run towards investing results. 

1 Total return over 10 years, 4/30/2010-4/29/2020 (Source: FactSet).

2 EM countries in the MSCI EM Index: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates, or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.

The MSCI China Index captures large and mid-cap representation across China A shares, H shares, B shares, Red chips, P chips, and foreign listings (e.g., ADRs), and covers about 85% of this China equity universe. The MSCI Emerging Markets Index (net) is a free float-adjusted market capitalization weighted index designed to measure equity market performance in the global emerging markets. The index is calculated on a total return basis with net dividends reinvested. The indexes are unmanaged, their returns do not reflect any fees, expenses, or sales charges, and they are not available for direct investment.

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