Until now, emerging markets have been bought on the growth of their underlying economies and the relative outperformance of their share markets over the past two decades. But investors can still do better than this. Traditional investment approaches are facing challenges in emerging markets, according to Dr Henry Zhao, CEO of Beijingbased Harvest Fund Management. With most emerging markets, such as China, having beaten Western economies for 20 years, some investors are looking to lighten up their exposures. However work by Dr Zhao and Harvest shows that there are better ways to construct a beta portfolio in China and other emerging markets than the traditional market capitalisation-weighted benchmarks. And because the emerging markets are still less efficient than developed markets, there is a lot of alpha to be had on top as well.

Using the main MSCI capweighted indexes, emerging markets have returned 622 per cent over 20 years through to 2010, compared with 277 per cent for developed markets in the same timeframe. Various fundamental indexes, such as that built by Research Affiliates (RAFI) or State Street, which do not follow market capitalisation weightings as slavishly, can be shown to outperform in both developed and emerging markets. For instance, a simple GDP Size Global Index, as reported last year by the International Monetary Fund (IMF), would have returned 3.36 per cent in the 10 years to 2009, compared with -0.34 per cent for the standard MSCI World. Other indexes using projected GDP growth from the IMF would have outperformed by more.

Dr Zhao said that, for Greater China (including Hong Kong and Taiwan), an index constructed of equally weighted stocks would have outperformed the MSCI China Index in three of the past four years, with a cumulative outperformance of more than 70 per cent in those years. In the China A-Shares market, the excess returns from an equalweighted index over the capweighted index was 11.62 per cent in 2010, 20.57 per cent in 2009, 3.99 per cent in 2008 and 33.32 per cent in 2007. “When investing in the China stock market, a beta linked to a large market cap-weighted index is not a good indicator to follow… A fundamental index should not be built on a pool of large-cap stocks only,” he said. “By taking the same amount of risk, equal-weighted indexes are better choices for beta measurements. Choosing the right benchmarks to follow is key for good returns and as a result an optimal beta structure is constructed.”

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