Index Futures and the Expansion of Equity Markets in EM and Asia

• Since the end of 2004, the size of equity markets in emerging markets (EM) and Asia grew significantly, as did the professionally managed asset pool targeting the region.
• Dispersion of subregional and single-market returns in EM and Asia has sometimes been sizable and was historically a bigger driver of stock performance than sectors and factors.
• Some investors may have used futures contracts based on regional and single-market indexes as they sought to complement their current investment process in EM and Asia.

The aggregate free-float market capitalization of the MSCI Emerging Markets Index and the MSCI Pacific ex Japan Index stood at USD 7.3 trillion and represented a 15.4% weight of the MSCI ACWI Index, as of June 30, 2020, compared with USD 1.8 trillion and an 8.5% weight at the end of 2004. The rise of market size in both absolute and relative terms reflects, in part, increased business productivity and dynamism in the EM and Asia, as well as expectations of the regions’ potential for future economic and financial-market growth.¹

Growth of EM and Asia Equity Active Asset Management

The period was also marked by the growth of regional-focused active strategies. During the 15-year period from 2004 to 2019, the aggregate assets of active EM and Asia regional funds tracked by the Thomson Reuters Eikon mutual-fund database grew at a 10.4% annualized rate, whereas the aggregate size of active EM and Asia single-market-focused funds grew at a 7.7% annualized rate.

The growth was supported, in part, by active managers’ ability to generate higher alpha in EM compared to the developed markets (DM) over the same period,² as well as the buildup of an EM derivatives ecosystem that extended the scope and flexibility of regional-based strategies.³

The Importance of Regional and Market Differences Within EM and Asia

The EM and Asia market is not a homogenous equity segment. To illustrate this, we break down EM and Asia into four subregions — Pacific; EM Asia; EM Europe, the Middle East and Africa (EMEA); and EM Latin America — and look at annual returns. The exhibit below shows that during the past decade, annual return dispersion between the best- and worst-performing subregions exceeded 30% at times.

Subregional Performance Rotations in EM and Asia

At the country level, the annual return dispersion of the best and worst performers reached as high as 70% at times, among the countries covered by the MSCI Emerging Markets Index.⁴

Given this wide dispersion of country-index returns, how did countries as a factor group explain individual stock performance over the period? The exhibit below shows that the country factors explained 40% to 80% of the systematic cross-sectional volatility (CSV) of both the MSCI Emerging Markets Index and the MSCI AC Asia Pacific Index from December 2004 to June 2020 — higher than the respective contributions from sectors and style factors.⁵

Importance of Country Factors in Driving Stock Performance Dispersion

How Some Investors Used Regional and Single-Country Index Futures

Given the dynamic performance rotation and dispersion across the subregions and countries of EM and Asia, some investors looked beyond traditional long-only approaches, including futures. Some have employed:

1. Directional strategies: Investors long or short a contract, or a basket of contracts for a certain time horizon.

   For example, investors may gain exposure to an MSCI Japan Index futures contract to reflect their views on short-term dislocation of the Japanese market, or they may use a combination of MSCI Pacific ex Japan and MSCI China Free contracts to match exposure to a developed Asia-plus-China portfolio.

2. Relative strategies: Investors match long position(s) with short position(s) within index futures to reflect their views on potential relative mispricing and market-dislocation opportunities.

   The exhibit below illustrates an example where an investor combined index-level fundamental data, such as price-to-forward-earnings ratio, to decide on tactical positioning of India vs. Taiwan.⁶

   Relative Price-to-Forward-Earnings Ratio and 1-Year Forward Return: India vs. Taiwan

   

   Box shows interquartile range (25th percentile to 75th percentile), and whisker shows minimum and maximum value. Dashed line in a box shows mean value.

3. Macro-rotational strategies: Investors use more complex country long/short strategies based on macroeconomic analysis, bottom-up fundamental analysis and quantitative signals.

   The exhibit below illustrates an example where an investor combined index-level price-to-forward-earnings ratio and three-month risk-adjusted momentum to rotate between long and short positions in a basket of EM and Asia single-market indexes.

Cumulative Performance of a Systematic Country-Rotation Strategy

We calculated monthly cross-sectional z-scores of three-month, risk-adjusted momentum and price-to-forward-earnings ratio for the MSCI China Free Index, MSCI India Index, MSCI Indonesia Index, MSCI Malaysia Index, MSCI Philippines Index, MSCI Taiwan Index, MSCI Thailand Index, MSCI Vietnam Index, MSCI Japan Index, MSCI Australia Index, MSCI Hong Kong Index, MSCI New Zealand Index and MSCI Singapore Index from December 2004 to June 2020. Index level is based on net total return in USD. Next, we calculated combined z-score for each index by subtracting z-score of price-to-forward-earnings ratio from z-score of three-month risk-adjusted momentum. Then, we calculated performance of a monthly rebalanced investment strategy that consists of an equally weighted long position of the three indexes with the highest combined z-scores and an equally weighted short position of the three indexes with lowest combined z-scores.

Investors may look to these approaches, and others, as they seek to enhance an existing investment process or potentially expand the scope of regional return sources.

The author thanks Shuo Xu, Wei Xu and Naoya Nishimura for their contributions to this post.

¹According to the International Monetary Fund, EM and Asia will continue to be the major growth driver of the global economy in the foreseeable future. “World Economic Outlook.” International Monetary Fund, June 2020. Net issuance of new shares (e.g., initial public offerings and additional issuance) contributed 80% and 70% to the growth of free-float market capitalization of the MSCI Emerging Markets Index and MSCI Asia Pacific Index, respectively, from December 2004 to June 2020.

²The average annual active returns of EM and DM active funds were 105 basis points (bps) and 65 bps, respectively, during the period April 2010 to February 2019. See: Melas, D. 2019. “The Future of Emerging Markets: 30 Years On from the Launch of the MSCI Emerging Markets Index.” MSCI Research Insight.

³Sammer, B., Haiss, P., Gartner, M., Loistl, O., Zellner, S., Merton, R., Rybinski, K., and Sowa, U. 2010. “The Impact of Derivatives Markets on Asset Management and the Economy.” SUERF Studies.

⁴In 2014, the MSCI India Index outperformed the MSCI Russia Index by roughly 70%.

⁵By comparison, based on our analysis, country factors explained 13% to 44% of the systematic CSV of the MSCI World Index from December 2004 to June 2020.

⁶Based on historical data from December 2004 to June 2020, the MSCI India Index more often outperformed the MSCI Taiwan Index during the subsequent one year when the starting relative price-to-forward-earnings ratio was below 0.8. On the other hand, the MSCI India Index more often underperformed the MSCI Taiwan Index during the subsequent one year when the starting relative price-to-forward-earnings ratio was above 1.5.

Further Reading

Asset allocation and index futures during market crises

Emerging Markets since China A shares’ inclusion

China and the future of equity allocations

Looking to the futures of emerging markets

Using multi-country multi-currency futures in portfolio management