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Emerging markets: From fringe to core holding Add to ...

Many investors see emerging markets as a wild area, prone to go bust, full of government interference and lacking in sound accounting standards. If you invest, the thinking goes, make it a small part of your portfolio.

That's why a fascinating recent article from Institutional Investor (via Abnormal Returns and Paul Kedrosky) sticks out: Big investors are increasingly looking at emerging markets as a core holding, either through direct stock purchases or exchange-traded funds that hold a basket of stocks.

"Many institutional investors are fundamentally rethinking their approach to emerging markets," says author Julie Segal. "Attracted by the powerful growth of economies in countries such as China, India and Brazil, investors have been putting more of their money in these markets. The debacle in Greece, concerns about the future of the euro and worries about debt levels in developed countries are providing more reasons for investors to shift their weightings."

According to the article, Richard Titherington, chief investment officer and head of the emerging-markets equity team at JPMorgan Asset Management in London, believes that the average pension fund thinks that it is overweight emerging market equities if it has a 5 per cent exposure. He thinks they should go to 20 per cent.

Some observers think that even that level of exposure is a little light. Maybe 50 per cent is the way to go. From the Institutional Investor article:

"Emerging markets constitute 13 per cent of the MSCI all country world index, so by that measure, most Western institutional investors are indeed underweight. But some analysts regard the MSCI weighting as excessively low. The index firm bases its weightings on the free float of shares in a given market; many emerging-markets companies have only a modest percentage of their shares in public hands, with the bulk still held by controlling families or governments.

"'Why should the somewhat arbitrary and fairly static rules of an index provider define useful investment allocations?' asks [Jerome Booth, head of research at Ashmore Investment Management in London] He contends that investors should have a 50 per cent exposure, which equals the emerging markets' share of global economic output based on purchasing-power parity. 'That's if they're neutral, not bullish,' he says."

This argument is particularly attractive today, given all the fretting over highly indebted developed markets, their unattractive demographics and the lacklustre performance of their stock markets.

Emerging markets, on the other hand, are looking increasingly responsible from a financial perspective, and their stock markets have outperformed their developed counterparts. Over the past decade, the MSCI emerging markets index has returned 7.6 per cent annualized. Over the same period (to June 1), the S&P 500 has fallen 1.3 per cent annualized.

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