- Emerging-market (EM) factor indexes have performed well long term, mirroring the pattern in developed-market (DM) factor indexes. The systematic risks and behavioral biases driving factor premia in DM may also extend to EM.
- EM factor indexes exhibited modest correlations with DM factor indexes, suggesting their performance was swayed more by unique local market conditions, which DM factor indexes may not fully capture.
- Country-specific effects contributed significantly to overall active risk in EM, higher than their impact in DM factors indexes, underscoring the importance of considering country effects in selecting EM investment strategies.
In 2023, the spotlight is shining again on emerging economies. Recent shifts in these markets, driven by reconfigured supply chains, enduring inflation and an escalating U.S.-China divide have made global headlines. Despite these developments, investor optimism persists. Inflows into emerging-market (EM) equity funds this year have matched those into developed-market (DM) funds, following a substantial lag in 2022.1
Investors are reassessing their EM allocations, with some seeking opportunities that extend beyond broad market exposure. Factor investing has emerged as a potential strategy. However, a recent MSCI survey revealed significant uncertainty among investors about the comparative risk-and-return benefits of EM and DM factor investing. In this blog post, we delve into how well-documented sources of excess returns in the developed markets have performed in the emerging markets.
Long-term outperformance of EM factors
We performed return simulations for six EM factor indexes — value, momentum, quality, low size, low volatility and yield — based on standard MSCI methodologies. We found that over the last two decades, all six factor indexes either outperformed or were less risky (or achieved both goals) compared to the broad-market MSCI Emerging Markets Index. This outcome suggests the systematic risks and behavioral biases underpinning factor premia in developed markets may also apply to emerging markets.
Six common EM factors have historically outperformed the broad emerging markets
Return is the annualized gross USD return from Dec. 31, 2001, (earliest available start date) through May 31, 2023. Volatility is the standard deviation of monthly returns.
Regional impacts on factor behavior
Performance of the six factors differed across regions. For instance, although exposure to profitable, high-quality or value-oriented firms generated positive active returns in the U.S., world ex U.S. and emerging regions, the size of the returns varied.
An illustrative case is value. EM value stocks exhibited greater resilience than DM value stocks during the decade-plus decline in the value premium after the 2008 global financial crisis. EM stocks also showed strong performance after November 2020, following the announcement of the COVID-19 vaccine.2 The announcement triggered a dramatic change in several factors, including a move out of growth into value stocks.
Factor performance across regions shared direction, but differed in magnitude
Returns are relative to each regional parent and stated in annualized gross USD terms from Dec. 31, 2001, through May 31, 2023. Red line indicates COVID-19 vaccine trial annoucement in November 2020.
Some EM factors leaned more local than global
We found that the active-return correlations between EM and DM factor indexes were generally weaker in comparison to those of the MSCI USA and MSCI World ex USA factor indexes. We also observed that certain factors were influenced more by local than global conditions. Fundamental factors such as size, quality, yield and value, which are responsive to local economic variations, had lower cross-regional correlations compared to more-technical factors such as momentum and low volatility.
This finding implies that EM factors exhibited a unique cyclicality, which may not have been fully captured by DM factors.
EM factor to US factor correlations tended to be the lowest across regions
Active correlations based on monthly gross returns in USD from Dec. 31, 2001, through May 31, 2023.
Sovereign risk a greater consideration in EM factors
In our final test, we assessed how EM factors were shaped by country-specific and local-market conditions. As we have shown before, the country-risk factor has historically been the largest driver of volatility in EM stocks, capturing political, regulatory and sovereign risks. An index’s tilts can also impact the country effects on risk and return. For instance, the MSCI Emerging Markets Value Index has historically favored firms in the region covered by the MSCI All Country Asia ex China Index as compared to stocks in China and Latin American regions.
Our analysis revealed that country risk contributed more to overall active risk in EM factor indexes than in DM factor indexes, which aligns with expectations given the typically higher country risk in emerging markets.3 Our finding highlights the necessity of measuring and, as needed, working to mitigate the impact of country risk.
Degree of country risk varied across the six EM factors
Active risk is relative to the parent universe and uses the MSCI Global Equity Factor Model. Values are monthly averages from Dec. 31, 2001, through May 31, 2023.
Our analysis uncovers the potential of factor investing in emerging markets and calls attention to the distinct performance attributes of EM factor indexes arising from the influence of local country dynamics. Although we do not discuss them here, other risks persist, such as EM currency risks and the investability issues stemming from concentration in a few key stocks. These departures from DM factor indexes reinforce the necessity for investors to fully understand the risks and opportunities when navigating emerging markets.
1Based on MSCI analysis of ETF and mutual-fund flows using Lipper Global Fund Classifications.
2The MSCI ACWI IMI Value Index has outperformed its growth counterpart by 17% in gross USD terms from November 2020 through May 2023.
3We constructed DM factors from the MSCI World Index, which encompasses both the USA and World ex USA regions.