Emerging markets have always offered a combination of higher potential returns and higher complexity – and Toby Watson’s perspective on how to navigate that combination is informed by direct experience of how these markets behave across very different economic and geopolitical conditions.
The case for emerging market exposure in a diversified portfolio has always rested on a combination of growth potential, valuation opportunity and diversification benefit. But realising that potential requires a more nuanced approach than simply buying a broad emerging market index and waiting. Toby Watson, whose career in international finance took him across markets in Europe, Asia and North America, brings a differentiated and practically grounded perspective to the questions that matter most when thinking about emerging market allocation in the current environment.
Emerging markets have undergone a significant reassessment in recent years, as the tailwinds that supported broad-based returns during the globalisation era have become less reliable. Geopolitical fragmentation, diverging growth trajectories, currency volatility and the uneven consequences of higher global interest rates have all contributed to a more differentiated picture in which country selection and risk assessment matter considerably more than before. Toby Watson, whose time at Goldman Sachs involved working across international markets and complex cross-border investment structures, developed a precise and analytically rigorous framework for thinking about emerging market risk and opportunity that continues to shape his investment thinking as a Partner in independent investment management.
What Emerging Markets Are and Why They Matter for Portfolio Construction
Emerging markets are broadly defined as economies developing more sophisticated financial systems and market infrastructure, typically characterised by higher growth potential, less liquid markets and greater political and economic volatility than developed markets. Toby Watson treats the emerging market category as a starting point for analysis rather than an endpoint – the diversity within the category is so significant that broad generalisation adds limited value.
The emerging market investment case has shifted considerably. Higher global interest rates have increased financing costs and put pressure on emerging market currencies; geopolitical fragmentation has affected trade relationships; and the divergence in growth trajectories between different emerging economies has become more pronounced. Toby Watson considers this a more demanding but also more interesting environment for selective emerging market investors.
A passive emerging market index gives significant weight to the largest markets by capitalisation, which does not necessarily correspond to the best risk-adjusted return opportunities. Toby Watson’s approach emphasises differentiation – distinguishing between markets with genuinely attractive fundamentals and those whose index weight reflects size rather than quality. That selective engagement requires more analytical effort but offers the potential for meaningfully better outcomes.
Risk, Volatility and Due Diligence in Emerging Markets
Description for this block. Use this space for describing your block. Any text will do. Description for this block. You can use this space for describing your block.Toby Watson identifies several risk categories deserving explicit assessment. Political and governance risk is often underweighted by investors focused on economic fundamentals. Currency risk is particularly significant, where exchange rate volatility can substantially affect returns measured in hard currencies. Liquidity risk is also more pronounced than in developed markets, particularly in periods of global risk aversion.
The most common mistake is treating emerging markets as a homogeneous asset class. The differences between individual emerging market economies – in terms of growth drivers, institutional quality, external vulnerabilities and geopolitical positioning – are often greater than the differences between developed and emerging markets as categories. Investors who fail to make those distinctions are likely to own risks they have not properly assessed.
Currency risk is one of the most practically significant and most frequently underestimated dimensions of emerging market investing. The real return of an emerging market investment depends not just on local market performance but on the currency translation back into the investor’s base currency. Toby Watson’s experience across international markets gives him a direct appreciation of how significantly currency moves can affect emerging market returns.
Toby Watson on Long-Term Allocation and Opportunity
For long-term investors, emerging markets offer genuine diversification benefit and access to growth dynamics not available in developed market portfolios. Toby Watson’s view is that the case for some emerging market exposure remains valid, but the composition of that exposure matters considerably more than it did in an era of broad-based outperformance. Among the considerations that should shape long-term allocation decisions are:
- The specific growth drivers of individual markets and whether they are structural or dependent on conditions that may not persist
- The quality of institutions and governance frameworks, which affect both the sustainability of growth and the protection of investor rights
- The external vulnerability of individual economies – their dependence on foreign capital, current account positions and exposure to commodity price cycles
Geopolitical fragmentation is reshaping the emerging market opportunity set in ways that make differentiation even more important. Markets well positioned within the new trade and supply chain alignments taking shape – either as beneficiaries of supply chain diversification or as part of emerging regional trade blocs – are likely to have different prospects from those that are more geopolitically exposed. Toby Watson considers geopolitical alignment an increasingly important variable in emerging market analysis.
Among the questions that Toby Watson considers most relevant when evaluating managers in this space are:
- Whether the manager has genuine on-the-ground research capability in the markets they cover, or whether their analysis is primarily conducted from a distance
- How the manager has navigated periods of emerging market stress in the past, and whether their risk management approach held up when conditions deteriorated
- Whether the manager’s approach is genuinely differentiated from the broad index, or whether active fees are being charged for what is effectively closet indexing
