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By Samuel Lee

The MSCI Emerging Markets Index yields 3%. Assuming a conservative real per-share dividend growth of 2%-3%, emerging markets look priced for ho-hum 5%-6% real expected returns over the long run. It looks a lot better when compared with cash's hideous negative 2% real yield, producing an attractive equity-risk premium of 7%-8%.

The big reason emerging markets are on sale is China’s economy is slowing, dragging down with it emerging markets hitched to its fortunes. The tried-and-true Chinese recipe for growth--calling for generous dollops of cheap credit to fuel real estate and infrastructure investments, never mind their profitability--is experiencing diminishing returns. Exports to the rich world are suffering. And there's that once-in-a-decade leadership change under way, introducing policy uncertainty. Investors fear China will enter a poorly managed recession. While I do think China will eventually experience a nasty financial crisis once all those politically motivated investments sour, I doubt it's going to happen anytime soon. China still has $3 trillion in foreign exchange reserves that it can tap into to patch up any holes, and it has able technocrats at the helm with every incentive in the world to make sure nothing downright terrible happens over the next few years.

Decades out, I'm not so sanguine. MIT professor Daron Acemoglu and Harvard professor James Robinson persuasively argue in their book Why Nations Fail that sustainable growth comes from inclusive political and economic institutions. By political inclusiveness, they mean many people can influence the political process, keeping elites from thoroughly looting the rest of society. By economic inclusiveness, they mean the existence of rule of law, private property, protection for intellectual property, and free labor and capital markets. Extractive institutions, on the other hand, concentrate political and economic power in the hands of a few, who inevitably end up stifling growth. While China’s Party elite has maintained enough economic inclusiveness to attract foreign investors, China’s political system is thoroughly extractive.

John Hempton of Bronte Capital makes a convincing case that China's combination of artificially low interest rates and high inflation is the main means by which the elite extract wealth from households. By paying negative real interest rates on deposits, the Party can channel subsidized loans to horrendously inefficient state-owned enterprises, which are controlled by politicians and their kin. By dint of their size, these enterprises are one of the biggest levers by which the elite can control the economy and dole out sops. While we foreign investors indirectly benefit from this regime by owning shares in state-owned enterprises, we have to be cognizant that we might end up being the piggy bank.

Acemoglu and Robinson argue extractive institutions--the kind prevalent in China--can lead to decades of stunning economic growth, as it did with the Soviet Union, simply by turning unproductive subsistence farmers into more-productive factory workers. But eventually the supply of cheap labor dwindles. Innovation (not just technological, but institutional and economic) is the only sustainable source of growth, and innovation is only possible with creative destruction. Unless China transitions to a more inclusive society, its growth will hit a wall--the "middle-income" trap so many other developing nations have fallen into.

To their credit, China's leaders are already well aware of these issues. They make all the right noises. The question is whether the political will is there to actually enact painful reforms that will inevitably hurt the elite's ability to loot households.

Do I think they will make this change? Yes. China likely will become the world power in the coming decades. But I suspect the transition to inclusive institutions will be slower and riskier than many believe. When the Soviet Union tried to transform itself into an inclusive society, it ended up in political and economic chaos. I think emerging-markets countries with more inclusive institutions at current valuations offer bigger margins of safety--Brazil and Taiwan, especially.

From this angle, SPDR S&P Emerging Markets Dividend (NYSEARCA:EDIV) fits the bill. It has an overweighting in Brazilian and Taiwanese stocks at the expense of equities from the most extractive countries, Russia and China. A dividend focus may provide a tilt to less extractive markets because firms enmeshed in a culture of looting are likely less interested in distributing earnings out to foreign shareholders.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Institutions Matter When Investing In Emerging Markets