By Cliff Quisenberry
Notwithstanding the market volatility of the past few months, emerging market equities are, and continue to be, firmly established as a dedicated asset class.
According to Standard & Poor's, the market capitalization of developing countries has more than doubled in the past decade — from less than $2 trillion in 1995 it is expected to exceed $7 trillion in 2006 — thus becoming an integral aspect of many portfolios.
The majority of flows into emerging markets have been directed to traditional active investment styles — strategies that rely on in-depth research of countries and securities to identify tactical, or short-term, opportunities. Conventional wisdom states that because these are the world's most inefficient equity markets, quality research can create information advantages and enhance performance. Investors accept higher costs and risks as part of this pursuit.
On the other end of the spectrum, a substantial amount of money is invested in indexed portfolios that track, most commonly, the capitalization-weighted indexes compiled by Standard & Poor's/International Finance Corp. and Morgan Stanley Capital International. Management fees and implementation costs are lower in this approach, but the investor must fully embrace both the positive and negative aspects of passive index investing.
There is a strong argument for a third strategy: a long-term commitment to these markets via a disciplined, rules-based or "structured" approach that can bring about a material improvement over, and/or serve as a complement to, both traditional active and passive strategies. In support of this assertion, we believe the equity markets of developing countries are exceptionally suited to structured portfolio management ideas such as equal weighting, systematic rebalancing and diversified economic sector and stock allocations within countries.