Emerging Asia is where the growth is, but your index fund might not find it

The growing middle class is fueling growth in emerging markets in Asia — but you won’t get much exposure to that in the typical emerging market index fund, said David Dali, portfolio strategist for Matthews Asia funds.

More than half the world’s population is in Asia, and the median age is 27, Mr. Dali said, speaking at a workshop at the Investments & Wealth Institute conference in Nashville, Tenn. Much of the population in Asia’s emerging markets is moving to cities from the countryside, and that means higher incomes for most.

“When people move to cities, they make 2.5 times the wages they did outside the cities,” he said. “In 1995, there were only three cities in Asia with more than 10 million people. Today, there are 28 cities with more than 10 million people, and 18 of them are in Asia.”

These new members of the middle class are the drivers of emerging market growth — not commodities, as many people think.

By 2030, middle-class spending in Asia will be $23 trillion a year, according to a 2017 Brookings Institute study. “In the past decade, over 400 million people in China have left poverty and joined the middle class,” Mr. Dali said.

How was that possible? China has made a massive effort to link its megacities and its smaller cities: The nation has built 152 airports in the past 20 years and laid 5,000 miles of high-speed railway in the past 10 years. Chinese train stations are fully automated and don’t take cash.

The result: Those who live in smaller cities can commute to megacities in 45 minutes and earn two to three times more than they would in the smaller cities.

“It’s changed everything,” Mr. Dali said. “Ten years ago, you couldn’t buy a pair of Nike shoes in the smaller cities. Now, Alibaba can get those new shoes to you in two days.”

Similarly, the Vietnamese economy is growing at 6% a year, the nation’s exports are growing 30% a year and wages are rising 9% a year, Mr. Dali said. “Vietnam, in my opinion, is the next big Asian tiger — the next one to graduate from frontier market to emerging market.”

Despite all the consumer growth in Asia, emerging market indexes typically are underweighted in consumer stocks, such as health care, utilities and consumer cyclicals. Instead, they tend to have lots of financial services and materials stocks.

“Add it all up, almost 80% of the [MSCI] emerging market index is cyclical,” Mr. Dali said. In large part, those cyclical stocks are what gives the emerging market index its reputation for volatility.

To improve emerging market performance and reduce volatility, you need more exposure to the burgeoning consumer class in Asia, he said. Health care in emerging Asia, for example, is only 3% of its gross domestic product, vs. 17.9% in the U.S.

While Mr. Dali recommends using index exposure to emerging markets, he says active management will provide additional exposure to smaller, consumer-oriented Asian companies.