Emerging markets (EM) are home to the world’s fastest-growing economies, where investing in companies with strong secular growth can lead to significant alpha generation over the long term. In the past several years, however, investors may have been disappointed by lack luster results from their EM allocations. The EM growth trajectory remains strong, so where’s the disconnect? Mainstream indices and low-tracking error investment approaches have been slow to reflect fundamental changes in EM growth and underrepresent dynamic secular growth companies, ultimately failing to adequately capture the multitude of opportunities that EM has to offer.

Institutional allocations to EM equities have increased steadily since the 1980s, as the asset class has evolved from frontier investment to growth mainstay. Over the past two decades, EM prosperity has been driven largely by export growth. While exports remain a significant component of developing world economic growth, massive expansion of the EM middle class—and its dramatic stimulation of domestic consumption—is poised to drive a differentiated source of EM growth. As the middle class expands and its disposable income increases, demand for numerous products and services rises. In 2019, EM countries posted average GDP growth of approximately 3.7%, substantially exceeding the 1.7% GDP growth of developed markets. This EM growth premium is expected to persist into the next decade. China, Indonesia, and Brazil are projected to grow twice as fast as developed markets countries, while India and the Philippines are expected to grow even faster, in the high single digits.

The success of investors seeking to translate EM’s premium structural growth into robust investment returns hinges on investment strategy. Investors in passive vehicles or low-tracking-error diversified funds relative to the MSCI Emerging Markets Index may be curtailing their growth prospects. Actively managed, high-conviction, benchmark-agnostic portfolios focused on companies that can generate superior growth and long-term returns offer better investment opportunities for several reasons.

First, the EM middle class’s burgeoning growth is creating secular growth opportunities for active investors. But not all EM companies have the solid fundamentals necessary to capitalize on the demographic change. Second, macroeconomic growth doesn’t necessarily translate into attractive equity returns. Rigorous research of individual company fundamentals can distinguish well-positioned businesses from disadvantaged companies. Third, active investors, particularly active growth, have won in EM. Active EM equity managers outperformed passive indices and, according to eVestment, active growth managers had the highest incidence of outperformance relative to the widely used MSCI Emerging Markets Index across both short and longer time periods.

Growth leadership over the past 10 years, as demonstrated by its superior performance relative to other categories, in part reflects the inherent construction of the EM index—namely its value bias and backward looking cap-weighted construct—which has made it easier for growth managers to outperform.

Investing in a passive or an overly diversified EM portfolio with a low tracking error relative to the MSCI EM index requires owning many cyclical, rate-sensitive companies and relatively few growth companies. The growth leaders of yesteryear—financials, energy, materials, industrials, telecom, and consumer cyclical—made up 45% of the index as of December 31, 2020. Furthermore, the index fails to reflect the dynamism and opportunities that exist in EM sectors with strong latent growth potential, such as healthcare, information technology, media, entertainment, consumer internet, and luxury goods. These sectors were 43% of the index at the end of 2020; an increase of 10% from 2019 due to growth’s out performance of value, but still not an adequate capturing of the opportunity set in EM.

Some EM strategies emphasize regional or country asset allocations with the rationale that, done well, they can offset shortfalls at the security selection and generate alpha. But EM investing demands a sharper toolkit than that because the fundamental revenue and earnings power of companies within regions will diverge meaningfully. According to a study published in the Journal of Financial Economics, of nearly 26,000 common stocks listed on the New York Stock Exchange, American Stock Exchange, and NASDAQ from 1926 to 2015, fewer than half generated a positive return during their time in the relevant index. The positive performance of the overall market was attributable to the large returns of relatively few stocks. Astoundingly, the 86 top-performing stocks—less than one-third of 1% of all stocks—accounted for half of the overall stock market’s gain, and less than 4% accounted for 100% of the stock market’s gain. Intrigued by these findings, we replicated this analysis for the MSCI EM index and found that over the last 20 years, 4% of companies in the index accounted for 100% of its return. This strongly suggests that investing in the right companies at meaningful weights is an important path to alpha generation.

Which companies are the “right” companies? Historically, they’ve been companies with superior earnings growth. Companies that are innovators and disruptors that re-imagined the way people live, work, play, and communicate. Skill, investment experience, and extensive industry knowledge are necessary to identify these early-stage-growth companies. As sell-side research coverage of EM companies is less extensive than coverage of developed market companies, consensus views of EM companies often either focus excessively on the short term or fail to fully price in the magnitude and duration of a company’s growth potential. Active EM growth managers find opportunity by discovering exploitable price differentials between their estimates of a company’s longer-term intrinsic value and shorter-term consensus expectations.

Investors wanting to tap into the powerful long-term benefits of EM’s superior structural growth trends can benefit from seeking out highly active strategies. The growth opportunity set is bigger than is generally thought. EM companies face challenges and problems different from those of their developed market counterparts, but their distinct circumstances often spur them to innovate and disrupt existing practices. EM companies are moving up the value chain, from export-oriented business models built on low-cost labor and cheap manufacturing to higher-value-added businesses based on technological and scientific innovation and consumer-driven growth. Low recognition of these dynamics by investors and indexes creates an opportunity for growth-minded investors. Add to the mix companies that execute well to exploit a superior economic growth backdrop, and the opportunity set expands.

Sara Moreno is an emerging markets portfolio manager at Jennison Associates.