Are Emerging Markets Poised for the Long Run?

It’s been a remarkable decade for the S&P 500 Index. Less so for global benchmarks.

Exhibit A: The MSCI Emerging Markets Index lagged the S&P 500 by over 200 percentage points cumulatively over the trailing 10-years—an average of more than 10% per year!

Cumulative Total Return

But the opposite was true in the 10 years before this period, when the emerging markets index beat the S&P 500 by a similar magnitude. Since 2001, the return of the MSCI Emerging Markets is still ahead of the S&P 500.

That is the story of diversification.

And while global allocators like WisdomTree would have given a similar story during recent years, our expectation is that this trend of U.S dominance will not continue forever.

What is One of the Best Ways to Own Emerging Markets?

One reason the U.S. has outperformed global benchmarks is its dominance in large-cap tech giants. Europe and Japan and the developed world indexes are notably lacking any big companies that have rivaled those U.S. tech stars.

In emerging markets, China is the country competing with the U.S. for tech dominance. The U.S. has FAANG, while China brings a BAT (Baidu, Alibaba and Tencent) of strong growers.

China also has up-and-coming tech stars like Pinduoduo, Bilibili and TAL Education, which are in e-commerce, online education and online entertainment, gaining share against the BAT and exhibiting strong performance.

WisdomTree has been a proponent of value investing since our inception in 2006, when we introduced dividend-weighted global portfolios.

Yet for emerging markets, many of our strategic model portfolios and core allocations are anchored with a growth-tilted core emerging markets holding—the WisdomTree Emerging Markets ex-Stated-Owned Enterprises Fund (XSOE).

For standardized performance of XSOE, please click here.

XSOE accomplished these results by following a simple two-step process:

1. Remove state-owned enterprises (SOEs): Identify all companies that have more than 20% ownership by the state. SOEs are most commonly found in China (almost half of all SOEs are in China), but also in banking and energy. Removing these means the remaining portfolio is overweight the technology and consumer sectors. These sector tilts were intentional elements of the strategy, and is a reason we believe this Fund is best aligned to the reason investors allocate to emerging markets in the first place—access to a large population that is seeing income levels catch up and grow relative to the developed world.
2. The WisdomTree Emerging Markets ex-State-Owned Enterprises Index (EMXSOE) follows a market cap-weighted approach designed to be country neutral (i.e., no large bets to diverge from our universe) while keeping sector tilts fairly balanced relative to our starting universe.

Let’s look at what factors have driven the Fund’s outperformance.

First, look at the returns of SOEs compared to those of non-SOEs since we launched EMXSOE.

• In the MSCI Emerging Markets Index, SOEs have declined 2.40% per year, while the non-SOEs have returned 3.58% per year.

• The 25% of the MSCI Emerging Markets Index that was exposed to SOEs dragged down the traditional benchmark returns.

WisdomTree’s methodology also delivered higher returns in the non-SOE segment—EMXSOE returns were 5.80% for non-SOEs compared to the MSCI Index returns of 3.58% in the non-SOE segment.

How much did the sector shift help?

As seen in the chart below, the allocation impact from sector deviations only represented 80 bps of the 354-bp total outperformance. Stock selection, and better returns within the sectors, was a key driver.

This is the impact from WisdomTree’s methodology removing SOEs, as both indexes follow a generally market capitalization-weighted approach.

In our view the decade ahead is unlikely to see the U.S. continue its major outperformance.

Emerging markets represent one of the global growth stories we see over the long run. To capitalize on this potential, we’d advocate for a growth-tilted core like XSOE.

¹As of 8/04/20.