Emerging Market Indices

Quick definition: Emerging market indices track stocks from roughly 20-30 developing countries—including China, India, Brazil, and others—that represent a smaller, faster-growing portion of global equity markets with higher volatility and growth potential.

Key Takeaways

• Emerging market indices include stocks from countries classified as having developing but increasingly sophisticated financial markets and economies
• MSCI Emerging Markets (the most widely used emerging market index) includes approximately 1,000 stocks from roughly 27 countries, representing about 12-15% of global market capitalization
• Emerging market stocks have historically offered higher growth potential than developed markets but with greater volatility and risks, including currency fluctuations and political instability
• Index composition is dominated by a few large countries—China and India typically comprise 50% or more of emerging market index weight—creating concentration risk
• The frontier markets category includes even less developed economies with greater risk but potentially higher growth prospects

Defining Emerging Markets

Emerging markets represent a middle category between developed and frontier markets. Countries classified as emerging have several characteristics: they have established stock exchanges and regulatory frameworks that are functional but less mature than developed markets, their economies are growing faster than developed economies (due partly to technological catch-up and partly to favorable demographics), and they have capital markets that are increasingly accessible to foreign investors.

The definition of "emerging market" isn't perfectly fixed. Index providers like MSCI maintain classification systems that determine which countries are emerging versus developed versus frontier. Countries can graduate from emerging status to developed status (as South Korea arguably has), or move from frontier to emerging as their institutions develop (as Vietnam has done in recent years).

The practical consequence is that emerging market indices change over time not just in composition (new companies entering, old companies exiting) but in actual country membership. A country addition to emerging market status receives attention from global capital flows, as funds tracking emerging market indices must add new positions and investors seeking emerging market exposure gain access to additional country opportunities.

MSCI Emerging Markets Index

The MSCI Emerging Markets Index (also called MSCI EM) is the most widely used emerging market benchmark. It includes approximately 1,000 stocks from roughly 27 countries. At any given time, EM comprises 10-15% of the global market capitalization represented by MSCI ACWI (the all-country index). This proportion changes as emerging market and developed market valuations shift—when emerging markets become cheaper relative to developed markets, their weight in global indices decreases, and vice versa.

The geographic composition of MSCI EM is heavily concentrated in a few large economies. China typically represents 30-40% of the index, making it the single largest country by far. India represents another 15-20%, Brazil approximately 5-10%, and Taiwan another 5-10%. South Korea, Russia, South Africa, and Mexico complete the top tier. Together, the top five countries typically comprise 70-80% of the emerging market index.

This concentration creates both opportunity and risk. It means that emerging market index returns are substantially driven by what happens in China and, to a lesser extent, India. If Chinese stocks surge, MSCI EM surges. If China underperforms, MSCI EM underperforms. Investors seeking broad emerging market diversification end up with significant China exposure whether they explicitly chose it or not.

Sector Representation in Emerging Markets

The sector composition of emerging market indices differs from developed market indices in important ways. Technology represents a larger share of emerging market indices than might initially be obvious because of Chinese technology companies. Alibaba, Tencent, and other large Chinese technology firms comprise a meaningful portion of MSCI EM. However, these are different types of technology companies than U.S. tech giants—Alibaba is primarily a retail/e-commerce platform rather than a software creator; Tencent is heavily involved in entertainment and gaming.

Financial institutions represent another large sector in emerging market indices, including banks and insurance companies from China, India, Brazil, and elsewhere. These financials serve developing economies and have different risk profiles than developed-market banks—they're generally less regulated and carry greater credit risk.

Consumer companies represent a meaningful allocation because consumers in emerging markets are growing wealthier. These include retailers, automobile manufacturers, and consumer goods companies capturing the consumption growth of expanding middle classes.

The specific sector mix varies over time as different sectors perform differently across regions. Understanding emerging market index composition requires appreciating that it's not simply "U.S. companies but in other countries"—the companies and sectors represented are substantively different from those dominating developed markets.

Risks and Volatility in Emerging Markets

Emerging market indices carry risks that developed market indices don't face to the same degree. Currency risk is substantial. When you invest in an emerging market index, your returns depend not only on stock prices but on exchange rates. If Indian rupees appreciate against the dollar while Indian stocks are flat, a dollar-based investor gains from currency appreciation. If rupees depreciate while stocks are flat, the investor loses from currency depreciation. Developed market investors typically don't face this currency impact to the same degree because they invest in dollar-denominated stocks (like U.S. stocks) that have global price visibility in dollars.

Political and regulatory risk represents another important emerging market consideration. Emerging market countries have less stable political systems and less predictable regulatory environments than developed countries. New regulations can significantly impact corporate profitability. Political instability can disrupt markets directly or indirectly affect business operations. Investors accepting emerging market risk must accept that these political and regulatory uncertainties are genuine factors affecting returns.

Liquidity and transparency issues can create challenges. Emerging market stocks trade less frequently than developed market stocks, meaning spreads between buying and selling prices are larger. Financial reporting standards, while improving, are less consistent than in developed markets. Corporate governance practices sometimes differ significantly from developed market norms. For index funds tracking emerging market indices, these practical challenges require careful portfolio management.

Valuation volatility is another emerging market characteristic. Emerging market stocks tend to move more dramatically than developed market stocks. In bull markets, when investors become enthusiastic about growth, emerging market valuations can soar. In bear markets, investors flee to safety, causing emerging market valuations to crater. A developed market bear market might see stock prices fall 20-30%; an emerging market bear market might see much sharper declines.

Historical Returns and Cycles

Emerging market index returns have experienced extended periods of outperformance and underperformance relative to developed markets. From 2000 to 2007, MSCI EM dramatically outperformed developed markets as commodity prices surged (benefiting commodity-exporting emerging market countries) and China's growth attracted global capital. From 2008 through 2020, developed markets significantly outperformed, particularly the United States.

This cyclical pattern means that buy-and-hold investors who invested in emerging markets at different times experienced very different outcomes. An investor who invested in MSCI EM in 2000 experienced exceptional subsequent returns. An investor who invested in 2010 experienced below-average returns for much of the following decade.

Over very long periods (30+ years), emerging market and developed market returns have been reasonably comparable after inflation, though with different volatility levels. This historical pattern supports holding some emerging market allocation without expecting dramatically superior returns compared to developed markets.

Frontier Markets and Beyond

Beyond emerging markets exists another category: frontier markets. These are countries classified as even less developed than traditional emerging markets—markets like Vietnam, Bangladesh, Pakistan, and Nigeria. Frontier market indices track stocks from these economies. They offer even higher growth potential than traditional emerging markets but come with even greater risk.

Some index providers also offer an "All-Country EM ex-Developed" category that includes all emerging and frontier markets as a single index. This provides even broader geographic diversification than traditional MSCI EM but concentrates more heavily in frontier market risks.

Comparing Emerging Market Index Providers

Like equity indices in developed markets, emerging market indices from different providers (MSCI, FTSE Russell, S&P) differ in their specific composition. MSCI EM is the most widely used, but alternative indices are available. The differences, while often subtle, can produce meaningful return divergences over time as different emerging markets are included or excluded or weighted differently between index families.

For most passive investors, the choice between different emerging market index providers matters less than the decision of how much emerging market exposure to include in a global portfolio. An investor choosing between MSCI EM and FTSE Emerging is making a minor methodological choice; the more important decision is what percentage of their global equity allocation should be to emerging markets.

Role in Passive Portfolios

For passive index investors, emerging market indices serve as the growth component of a global equity allocation. An investor might structure a global equity portfolio as 85% developed markets (via MSCI World) and 15% emerging markets (via MSCI EM). This allocation captures global diversification while accepting that emerging market volatility will create shorter-term performance divergence from developed markets.

The specific allocation decision depends on personal views about emerging market growth prospects and tolerance for volatility. Some investors accept the market-weight allocation implicit in MSCI ACWI (roughly 85-90% developed, 10-15% emerging). Others underweight emerging markets due to concern about risks. A few might overweight them expecting superior long-term growth.

Process

Next

Having examined different equity index categories—global, developed, and emerging—we now turn to specialized equity indices that slice the market differently. In our next article, we explore sector and thematic indices, which divide the global market by industry or theme rather than geography.