What drives emerging market equity returns and how do they differ from developed market returns?

Question

AcadiFi · Accepted Answer

Emerging market (EM) equity returns can be decomposed into: (1) earnings growth, (2) dividend yield, (3) multiple expansion/contraction, (4) currency effect, (5) country risk premium changes.

R_USD ≈ R_local + FX_return
R_local ≈ EPS growth + (P/E change) + dividend yield

Unique EM drivers:

1. HIGHER NOMINAL GROWTH: EM GDP growth historically 2-3x developed markets (e.g., India at 6-7% vs. US 2%). In theory this feeds earnings.

2. HIGHER VOLATILITY: Annualized vol of 22-28% vs. 15-17% for developed. EM crises (1997 Asia, 2018 Argentina/Turkey) drive drawdowns of 40-60%.

3. COMMODITY LINKAGE: EM indices are often heavy in energy/materials (Brazil, Russia, South Africa), making them procyclical to commodity cycles.

4. CURRENCY REGIME: Persistent depreciation of EM currencies vs. USD (1-3% per year on average) erodes USD returns. Investors demand higher local returns to compensate.

5. POLITICAL / POLICY RISK: Expropriation risk, capital controls, regulatory reversals.

Forecasting example: Coralmont EM Equity Fund projects 2026-2030 returns:
- Earnings growth: 8% (real GDP 5% + inflation 3%)
- P/E reversion: +1% per year (from 12x to 14x)
- Dividend yield: 3%
- FX drag: −1.5%
- Gross USD return: 8 + 1 + 3 − 1.5 = 10.5%
- Risk premium: 6.3% over 3-mo T-bill

Historically realized EM returns often disappoint because 'growth' doesn't translate to per-share earnings (share issuance dilution in many EM firms exceeds 2% annually). The famous Bernstein/Arnott finding: EM per-share EPS growth has been roughly equal to or less than developed markets despite higher GDP growth.

Exam tip: don't confuse GDP growth with equity returns — they're linked but not identical.

What drives emerging market equity returns and how do they differ from developed market returns?

Master Level II with our CFA Course

Related Questions

Practice Questions