THE concept of an “emerging-markets (EM) asset class” may no longer be a sufficiently useful and accurate catch-all classification for investors.

The implications of this shift are important given the concept’s pervasive influence on asset allocation methodologies, benchmarking and even the way investment companies (and their service providers) are organised. The category also determines how allocators of capital review their portfolio decisions, especially at the beginning of a quarter.

To understand why EM may be losing its prominence as an analytical tool, let’s start with the three elements that typically define an asset class:

First, its components share similar characteristics: geographic location, for example, or much more importantly for investment purposes, economic and financial commonalities. These similarities allow the investments to be modelled relatively coherently for expected return, volatility and correlations with other asset classes. Yet these assets aren’t so completely homogeneous that they can be replicated via a single instrument, which also opens the possibility of out-performance thanks to active management.

Second, the majority of the components of the asset class are sensitive to an external influence that is strong enough and sufficiently encompassing to have a similar impact across the board. This can take the form of a single variable, such as the price of oil for producers, or it can be linked to a policy, such as the effect of the European Central Bank’s quantitative easing on sovereign bonds.

Third, the actions of investors impose a self-reinforcing consistency in the way individual elements of the asset class relate to one another. This could be the case, for example, when the bulk of investors use a predominantly top-down approach — which takes into account the asset class as a whole rather than its individual components — or when markets are overwhelmed by large tides of capital, be they inflows or outflows.

EM has grown markedly since its relatively modest beginnings, and it now contains far too much diversity to meet the first requirement of shared characteristics. It no longer qualifies for the second criterion, especially now that the comments and actions of a single policymaking body, such as the International Monetary Fund, don’t move markets as they once did. The third characteristic — the propensity of investors to look at such an asset class as a unit rather than as the sum of its parts — still plays a role, giving rise to interesting dynamics.

Macro decisions to allocate or withdraw capital from EM — particularly through index and index-like vehicles — tend to be significant drivers of return, volatility and correlation behaviours, which too often lead to valuations that are decoupled from individual fundamentals. The resulting overshoots — on the way up or down — generate risks and opportunities not just for investors but also for the issuers of securities they transact in.

It is important to note that these distortions aren’t caused by irrationality or malfunctioning markets. Instead, they reflect the evolution of an asset class that, at its inception, was underpinned by investor behaviours devised around common economic and financial attributes. It has since failed to keep pace with the increasingly diversified and divergent realities on the ground.

In the case of EM, this phenomenon is amplified as the market influence of a relatively small base of dedicated investors is subject to the vagaries of less well-informed “crossover” funds (that is “tourist” capital that, rather than being attracted by the attributes of the asset class itself, is driven to invest by fluctuating circumstances at home, and thus is far less stable). — Bloomberg

This article first appeared in The Edge Financial Daily, on April 6, 2015.