There is a phenomenon in emerging markets (EM) of government actors investing alongside other investors in publicly traded equities. We’ve previously made the case that state-owned enterprises (SOEs) in emerging markets are prone to conflicts between the interests of shareholders and government stakeholders. The key issue is to whom the company answers: shareholders or government stakeholders. In our view, companies with meaningful government ownership are often run as much for government benefit as for their shareholders. Problems arise for investors when these interests are not aligned and possibly affect their profitability and future returns. Companies that align management’s and shareholders’ interests are considered compliant with the “G” in ESG (environmental, social and governance) factors used to measure sustainability and responsibility.
The first and probably most critical issue regards whether SOEs and ex-state-owned companies (non-SOEs) have performed differently. Intuition tells us that if shareholder returns and fundamentals such as return on equity (ROE) are not a company’s top priority, this should be reflected in decreased returns and greater risk. To prove this theory, we built broad market capitalization-weighted portfolios of state-owned and non-state-owned EM companies. State ownership is defined as those firms that have more than 20% of their shares owned by government entities.
Performance of SOEs vs. Non-SOEs in Emerging Markets
The data shows us that over this period there was a cumulative difference of more than 60 percentage points between the performance of non-SOEs and SOEs, while also exhibiting lower volatility. Focusing on the most recent calendar year, we can see how non-SOEs outperformed and contributed 85% of the MSCI EM Index’s return despite having a 75% weight.
Another area of consideration has to do with fundamentals. If, in fact, SOEs are managed in ways that do not favor shareholders’ interests, this should show up in “lower quality” or “less efficient” fundamental metrics. Using ROE as a quality proxy, we can see how non-SOEs had a distinct advantage over this time period, with the difference relative to SOEs widening in the most recent periods.
Return on Equity over time (12/31/07–3/31/18)
The WisdomTree Emerging Markets ex-State-Owned Enterprises Index (EMXSOE) provides exposure to companies in which the government owns less than 20%. We believe that exposure to non-SOEs is a more efficient way to approach EM equity markets for investors that want to mitigate risks inherent in investing alongside governments. Investing in companies that have shareholder interests as a top priority has proven to be a way to tap into quality, which could lead to potentially higher expected returns. For a deeper look, check out our full white paper on the Emerging Markets ex-State-Owned Enterprises strategy.