Emerging Market Equities: Navigating Cost Efficiency and Risk-Adjusted Returns in a Shifting Landscape

Emerging market equities have long been a double-edged sword for investors: offering the allure of high growth but burdened by volatility, regulatory risks, and structural inefficiencies. As of September 2025, the landscape is evolving, with new academic insights and strategic innovations reshaping how investors approach cost efficiency and risk-adjusted returns in these markets.

The Profitability Premium: A New Lens for Emerging Markets

Traditional asset pricing models, such as the Fama–French five-factor framework, have struggled to explain returns in emerging markets. Recent studies reveal that profitability (RMW) is the most significant factor in these contexts, outperforming even the market factor, according to a Fama–French study. This challenges conventional wisdom, which often prioritizes broad market exposure. For instance, firms with strong profitability metrics have consistently delivered superior returns in emerging markets, suggesting that investors should prioritize quality over size or momentum. This shift underscores the need for strategies that drill down into firm-level fundamentals rather than relying on macroeconomic trends alone.

Smart Beta Strategies: Promise and Pitfalls

Smart beta strategies-rules-based approaches that weight portfolios by factors like profitability, momentum, or equal weighting-have gained traction as tools to enhance cost efficiency and risk management. Data from 2023–2025 shows mixed results. For example, the EM Enhanced Index (Systematic Active) strategy targets excess returns of 0.75% to 1.00% with low tracking error (0.25% to 1.75%), while the EM Equity Select (Fundamental Active) aims for higher returns (over 3%) but with significantly greater volatility, as the Fama–French study noted.

However, a critical analysis of five smart beta funds (JPEM, EMGF, GEM, PXH, and FNDE) against the MSCI Emerging Markets Index reveals a nuanced picture. While PXH and FNDE showed higher average monthly returns and 2-year holding period returns compared to the index, none of the funds outperformed the benchmark at conventional significance levels, according to an IJMTP analysis. This highlights the cyclical nature of factor performance: momentum or value factors may dominate in certain periods, but their effectiveness wanes in others. Investors must balance short-term underperformance with the potential for long-term outperformance.

Cost Efficiency and Risk-Adjusted Returns: A Delicate Balance

Cost efficiency remains a cornerstone of emerging market investing. Smart beta strategies often reduce costs by automating decision-making and minimizing active management fees. Yet, their impact on risk-adjusted returns-measured by metrics like the Sharpe ratio-is inconsistent. A 12-year MDPI study of EU-domiciled smart beta ETFs found that only equal and momentum weighting strategies improved risk-adjusted returns, while others lagged. This suggests that not all smart beta approaches are created equal. Investors must scrutinize the specific factors and weighting mechanisms employed by each strategy.

The Road Ahead: Strategic Recommendations

For investors seeking to optimize emerging market equity portfolios, the evidence points to three key strategies:1. Prioritize Profitability: Allocate capital to firms with strong earnings and cash flow generation, as these have historically outperformed in volatile markets, as shown in the Fama–French study.2. Adopt Long-Term Horizons: Factor performance is cyclical, and smart beta strategies may require extended periods to demonstrate their value, a point emphasized by the IJMTP analysis.3. Diversify Factor Exposure: Combine profitability-focused strategies with equal or momentum weighting to balance cost efficiency and risk management, consistent with the MDPI study's findings.

Emerging markets remain a complex but potentially rewarding asset class. By leveraging profitability-driven analysis and smart beta innovations, investors can navigate the turbulence of these markets while enhancing returns and mitigating costs.