A combination of these structural and behavioural inefficiencies leads to persistent mispricings, regardless of investment styles. For active managers with a disciplined and repeatable investment process, these inefficiencies provide opportunities to identify underappreciated future winners and avoid value traps.
By focusing on long-term, risk-adjusted returns driven by stockspecific fundamentals — rather than broad market movements — active investors in EMs are better positioned to deliver sustained alpha than passive investors tracking an index. Furthermore, these inefficiencies are persistent and reflective of these nations’ status as developing economies, meaning an active approach will remain relevant for many years to come.
Investing in businesses, not just indices
Investing in emerging markets is not just about what’s in the index — it’s also about what’s missing. Adding off-benchmark stocks to a portfolio has several well-documented benefits, including enhanced diversification, increased alpha potential, or the ability to access markets or regions underrepresented in traditional indices. Active EM investors can pursue off-benchmark opportunities by investing in EM stocks that are not included in benchmark indices or in DM-listed companies with significant emerging market exposure.
When evaluating EM-listed stocks outside the benchmark, it’s easy to assume their exclusion signals poor quality — but that’s not necessarily true. Many successful companies remain outside the index for reasons unrelated to their fundamentals. Some may be early-stage businesses experiencing rapid growth but not yet meeting market capitalisation, balance sheet strength, or liquidity thresholds. Others may face regulatory or transparency hurdles that could be addressed through improved governance and oversight.
Additionally, companies – or even entire markets – may be in the process of securing index inclusion, a transition that takes time to complete. Take Vietnam — a high-growth economy still classified as a frontier market but poised for MSCI EM inclusion. Passive investors miss early-stage gains that active managers can capture. Over the past year, Vietnam’s role as an AI supply chain hub has expanded as firms diversify away from China amid geopolitical and tariff concerns. Its omission from the index signals not inferiority, but future potential.
Including DM-listed companies with significant EM exposure brings a different dimension to the portfolio. In the instance of these larger, more established firms, their inclusion can enhance the overall growth and revenue profile of the portfolio, through their EM exposure, but also benefit from the enhanced downside protection inherent with being a DM-listed company i.e. reduced direct geopolitical risk for example.
Looking past headline valuations
Skilled bottom-up stock pickers can identify mispriced opportunities irrespective of broader market valuations at any stage of the cycle. A sector or country may appear expensive at the index level, potentially deterring investment. For example, India’s valuations have risen, as noted here. However, active management allows investors to uncover individual Indian companies with strong earnings potential or expanding market share, even in a higher-valuation environment.
Mitigating risks through active management
In emerging markets, avoiding the bad apples can be as important as picking the winners when it comes to generating alpha. A key benefit of active over passive investing is the ability to navigate a variety of risks that can compromise alpha.
Resilience and governance
Investment approaches that incorporate deep fundamental analysis can help to mitigate risks. Emerging market companies that demonstrate strong operational and ethical standards will likely be less exposed to regulatory sanctions, reputational damage, consumer opposition, talent loss, and other risks to their intrinsic value.
There is a common perception that governance standards in emerging markets are lower. While this is not universally true, certain areas require heightened scrutiny from active investors. Passive investing provides broad exposure to underlying securities but lacks the ability to assess individual governance frameworks, such as board composition and related-party transactions. In contrast, active investors can conduct detailed evaluations of financials, director proposals, and key stakeholder dynamics, offering a more informed approach to managing financial and reputational risk.
Consumer expectations in emerging markets are also shifting. Just like in developed markets, people are increasingly focused on corporate responsibility, including environmental impact, labour practices, and ethical business conduct. Companies that fail to adapt to these changing priorities may face growing scrutiny.
Active investors play a critical role in engaging with companies to assess sustainability-related risks and opportunities. This is particularly valuable in emerging markets, where data availability is limited, and quality can be inconsistent.
Geopolitical and regulatory risk
Overexposure to either regulatory or geopolitical risks can potentially impair a company’s business model and operating performance. One market where these risks are particularly pertinent is China. The government has penalised tech and internet companies in recent years, promoting ‘Common Prosperity’ across China, by reducing the influence and reach of the major companies to safeguard social, economic, health and family welfare ideals. Active managers are better placed to weigh these risks at the individual company level to navigate the regulatory uncertainties.
Furthermore, with Trump back in office, attention has once again turned to US-China geopolitical relations. However, after eight years of adapting to Trump-era trade policies, China is now far more resilient to additional measures. Today, only around 13% of Chinese exports go to the US, down from 20% in 2014 — a 35% reduction. Active management enables investors to identify new beneficiaries of these shifting trade patterns and capitalise on evolving opportunities. While the future trajectory of trade tensions and tariffs remains uncertain, integrating geopolitical considerations into company specific analysis is essential for assessing risk-return trade-offs.
Corporate governance also plays a critical role in mitigating value destruction from sanction risks. Active investors conduct in-depth analysis of ownership structures, business activities, and related-party transactions to assess potential exposure. By scrutinising value chains, they can identify and manage links to sanctioned entities, strengthening portfolio resilience.
Concentration risks
Traditional emerging market indices contain fewer mega-cap companies than their developed market counterparts, often resulting in large-cap stocks carrying disproportionate weightings. Taiwan Semiconductor Manufacturing Company (TSMC) illustrates this dynamic when compared to US tech giant NVIDIA. NVIDIA, with a market capitalisation of approximately US$3.2 trillion4, represents around 4% of the MSCI All Country World Index. In contrast, TSMC, with a market cap of roughly US$800 billion — one-fifth the size of NVIDIA — accounts for 9.6% of the MSCI Emerging Markets Index and nearly 50% of Taiwan’s overall index weighting. While TSMC’s dominance in the semiconductor industry has driven significant growth, maintaining this position will be crucial for sustaining future share price performance.
This level of concentration is a key risk in passive portfolios, particularly if future returns do not align with past performance. While portfolio management constraints may limit exposure to individual stocks beyond 10%, active management provides the flexibility to size positions appropriately, mitigating the return impact of an over-weighted single stock.
The bottom line
Emerging markets remain a fertile ground for active management, where structural inefficiencies and market complexities create opportunities beyond passive exposure. Unlike developed markets, where efficiency has eroded alpha, EMs continue to reward research – driven stock selection and off-benchmark investing. These efficiencies are set to persist given the regions continuing economic development and rapid growth.
Long-term data shows that active managers have consistently delivered excess returns, even after fees. Market inefficiencies — stemming from drivers including lower liquidity, regulatory barriers, and high retail investor participation — lead to persistent mispricings that skilled investors can exploit. Moreover, active strategies provide the flexibility to navigate governance risks, geopolitical shifts, and index concentration, areas where passive funds fall short.
In a market where risk and opportunity are closely intertwined, a selective, research-led approach is essential. Active investors not only seek alpha but also manage risks that can erode returns, reinforcing their edge in capturing long-term value in emerging markets.
1 From Warren paper: see Huij and Post, 2011(63); Dyck et al. 2013(64); Gallagher et al. 2017(65).
2 Global consultant research fee report.
3 Actual fees for seg mandates at US$100m for consultant-advised clients.
4 Bloomberg, November 2024. This is not a buy, sell or hold recommendation for any particular security.