Does it make sense for a South African investor to invest in (other) emerging markets?

South African investors often favour developed markets (DM) for their global diversification, perceiving them as safer due to their robust financial systems and overall economic stability. However, this focus can result in a missed opportunity to capitalise on the high-growth potential found in other emerging markets (EM). For South African investors, diversifying into emerging markets provides not only the chance for a different source of returns but also a broader, more balanced risk exposure.

The diversification advantage

One of the main reasons for South African investors to consider emerging markets is the diversification benefits. Companies on the JSE All Share Index are primarily exposed to African economies, with over 50% of revenue from the continent, with the bulk from South Africa. Conversely, the MSCI Emerging Markets Index features 48.6% revenue exposure to high-growth regions in Asia, including China and India. These markets offer investors access to varied economic cycles and sectors that complement US-centric developed markets and local investments. 
Figure 1: Index revenue exposure by geographic distribution of company revenues

The JSE’s concentration on financials and basic materials ties its performance closely to local economic conditions and commodity prices, which can increase risk during downturns. In contrast, emerging markets provide a more balanced sectoral exposure, with significant representation in fast-growing industries like technology. 

Figure 2: Index sector exposure by market capitalisation weights

The diverse geographic and sectoral exposure within emerging markets adds portfolio resilience, especially during US-centric or South Africa-specific economic downturns. This can provide balance and potentially reduce volatility.

Currency stability and risk 

The South African rand is known for its volatility, which poses a risk when investing in foreign assets. As illustrated in figure 3, returns from the MSCI Emerging Markets Index are less directly correlated with the rand-dollar exchange rate fluctuations than returns from developed markets. The stronger correlation of developed market returns with currency fluctuations, mainly because of US-dollar-denominated assets, implies that emerging markets might provide more stable returns in rand terms. It is important to note that this is a currency (USD) effect, not an inherent feature of the developed markets’ performance. In contrast, emerging markets have more currency diversification, reducing the direct impact of the rand-dollar rate on their returns in rand terms. This currency diversification could make emerging markets attractive for South African investors looking to reduce the impact of rand volatility on their portfolios.

Figure 3: Relative performance of EM and DM vs SA compared to rand-dollar exchange rate movements

Valuation and growth potential

Emerging markets are often valued at a discount compared to developed markets. Price-to-book (P/B) ratios are commonly lower in emerging markets, providing a “value play” for investors. Historically, these valuations have ranged from 1.2 to 1.8 for emerging markets, while developed markets like the MSCI World Index hover between 2.5 and 3.5, driven mainly by high-growth US tech companies more recently. This valuation gap indicates that emerging markets offer a long-term opportunity for capital growth, particularly as these economies continue to mature and expand.

Risk and reward

Emerging markets present a compelling opportunity, but they are not without their risks. Analysing rolling returns reveals a pattern of cyclical outperformance, where emerging markets often lead during economic upswings but may underperform during global recessions. For example, the MSCI Emerging Markets Index showed strong relative returns to the JSE All Share from 2005 to 2015 but struggled in recent years due to global inflation and political tensions. Despite these challenges, the cyclical nature of emerging markets can enhance the resilience of a diversified portfolio by balancing high-growth periods with more stable developed markets.

Figure 4: 3 Years rolling relative return to SA equity

An analysis of drawdowns further highlights the risks involved. Historical data show that emerging markets face more prolonged recoveries from downturns than developed markets, partly due to the heightened political and economic uncertainties in these regions. For South African investors, balancing exposure across both emerging and developed markets can smooth out portfolio returns, especially during volatile periods, and prevent reliance on a single economic region for recovery. 

While developed markets provide stability, emerging markets bring growth potential and diversification which can be particularly beneficial to South African investors. The risks associated with emerging markets, including political volatility and currency fluctuations, may deter some investors, but these can be mitigated with a well-balanced, diversified approach. A long-term strategy with a dedicated allocation to emerging markets allows investors to tap into high-growth sectors and regions, creating a more resilient and growth-oriented portfolio.

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