Capital Deployment in 2026: Why Institutions Should Consider Shifting to Emerging Markets

Emerging Markets: A High-Conviction Institutional Opportunity

Emerging markets have become a top pick for institutional investors, driven by a strategic shift in global portfolio allocation. Despite a robust rally in 2025, these markets remain underrepresented in many investment portfolios, setting the stage for continued inflows. This is not a short-term trend but a significant repositioning, as seen in record-breaking capital movements and a rally that is outpacing developed economies.

Current data highlights that global investors are still holding relatively low positions in emerging markets. Even after a 33.6% surge in 2025, research from State Street Global Markets indicates that many remain underweight in this asset class. This underexposure suggests there is ample room for additional investment, with many institutions beginning to adjust their allocations to at least a neutral stance.

Recent fund flows confirm that this rotation is well underway. In 2025, emerging market equity funds experienced their strongest inflows since the post-pandemic rebound, with nearly $88 billion pouring into EM ETFs. The trend has persisted into 2026, as the iShares MSCI Emerging Markets ETF attracted over $4 billion in January alone—the highest monthly inflow since 2015. These investments are not limited to a single theme; for example, South Korea received more than $1 billion in February, reflecting growing institutional confidence across regions.

This influx of capital is fueling a market that is increasingly moving independently from developed economies. While the S&P 500 has remained relatively flat this year, emerging markets have surged ahead. The MSCI Emerging Markets Index has climbed nearly 13% year-to-date, led by exceptional gains in South Korea, where the iShares MSCI South Korea ETF has risen 43.28%. This global revaluation has resulted in the widest performance gap between EM and the S&P 500 since 2010.

In summary, the alignment of capital flows, portfolio positioning, and market performance is creating a compelling environment for emerging markets. Institutions are shifting from underweight to neutral or overweight positions, motivated by strong fundamentals such as anticipated double-digit earnings growth and a rally that is decoupling from developed markets. For asset allocators, this combination of light positioning, robust fundamentals, and accelerating inflows presents a high-conviction opportunity.

Building Portfolios: Sector Rotation and Quality Focus

The current macro environment and market rally provide a clear tactical roadmap for portfolio construction. Institutional investors are not just increasing exposure to emerging markets as a whole, but are targeting high-quality sectors that are benefiting from the global AI boom. This rotation favors cyclical, capital-intensive industries where demand is driven by long-term trends rather than speculation. A prime example is the AI-driven semiconductor sector, which has propelled South Korea’s market. The iShares MSCI South Korea ETF’s 43.28% year-to-date gain is largely attributed to leading chipmakers like Samsung and SK Hynix, who are capitalizing on strong global demand for advanced memory and AI semiconductors. For portfolio managers, this is a classic quality play—investing in companies with sustainable competitive advantages, pricing power, and exposure to major secular trends. This shift reallocates capital from riskier, speculative segments to proven growth engines.

This sector-focused approach supports a broader, conviction-level allocation to emerging market equities. The institutional strategy now favors an overweight position in EM equities, maintaining a neutral stance on the US dollar and an underweight in developed market equities. This is a long-term repositioning, not just a tactical move. The rationale is clear: emerging markets offer better risk-adjusted returns, combining exposure to accelerating global growth—especially in manufacturing and trade—with more attractive valuations than developed markets. The quality factor, bolstered by AI and semiconductor demand, is driving profitability and supporting valuations above the decade average, justifying the overweight allocation.

For portfolio construction, a multi-pronged strategy is recommended. First, maintain a core overweight in emerging markets, taking advantage of ongoing light positioning and broad-based inflows. Second, tilt allocations toward high-quality, cyclical sectors such as semiconductors, where the strongest growth drivers are evident. Third, keep the US dollar position neutral, recognizing the potential for further weakness but not actively betting against it. This approach aims to capture the relative value and return opportunities from the EM rotation, with a focus on quality to manage volatility and secure exposure to long-term growth trends.

Risk-Adjusted Returns and Macro Tailwinds

The main macro driver behind the institutional case for emerging markets is a weakening US dollar. This trend was central to EM outperformance in 2025 and remains a key factor for 2026. The dollar appears poised to break a long-standing upward trend, a technical shift that could lead to further declines. Expectations of additional Federal Reserve rate cuts and a US administration supportive of a weaker dollar to improve trade balances increase the likelihood of a sustained downturn. This structural change is further reinforced by global efforts to diversify away from the dollar amid a climate of frequent sanctions. For investors, a weaker dollar directly boosts EM returns, enhancing their risk-adjusted appeal.

However, this same macro tailwind also presents the primary risk. Should the dollar reverse course, it would undermine the foundation of the recent EM rally. A stronger dollar makes EM assets more expensive for foreign investors and can prompt capital outflows. The risk is not just a short-term technical rebound but could stem from significant changes in US monetary or trade policy, potentially reversing the dollar’s decline. This creates a binary risk: the investment thesis is highly sensitive to the dollar’s direction.

Other risks are also emerging. Geopolitical tensions continue to pose threats to trade and investor confidence. More importantly, the earnings growth that has fueled the rally may not be sustainable. After a stellar 2025, there is a risk that EM corporate profits could slow, putting pressure on valuations and limiting further gains in high-quality cyclical sectors. The AI semiconductor cycle, while a strong catalyst now, may not maintain its current pace indefinitely.

Ultimately, investors face a trade-off between a strong macro tailwind and identifiable risks. While a weakening dollar supports EM returns, any reversal would be a significant setback. At the same time, portfolios must be managed to withstand potential earnings slowdowns and geopolitical shocks. For institutions, an overweight position in EM is not a passive bet but requires active monitoring of these macro and fundamental risks. The opportunity offers an attractive risk premium, but it is not without challenges.

Key Catalysts and Monitoring Points for Institutional Investors

For portfolio managers, the structural shift into emerging markets is an active strategy. The institutional playbook involves tracking several forward-looking indicators to confirm the trend’s durability and spot potential turning points. While the current environment is favorable, the thesis depends on a few critical catalysts.

• US Dollar Technical Break: The most immediate catalyst is the potential technical breakdown of the US dollar. The US Dollar Index is nearing a break of its long-term uptrend. A decisive move below this level would reinforce the macro tailwind and support ongoing EM outperformance. This is the primary technical signal to monitor; failure to break lower could trigger short-term volatility and capital outflows from EM assets.
• Institutional Flow Breadth and Sustainability: Recent inflows have been substantial, with the iShares MSCI Emerging Markets ETF drawing over $4 billion in January 2026. However, it is crucial that these flows remain broad-based rather than concentrated in a single theme like AI semiconductors. The rally has included diverse markets such as Peru, Brazil, Thailand, and Turkey. Portfolio managers should watch for continued diversification; a narrowing of flows could indicate a speculative peak rather than a sustained rotation.
• Fundamental Earnings Momentum: The rally’s foundation is accelerating earnings, tied to a broad economic recovery and improving global growth. While developed markets outside the US are gaining strength, emerging market growth remains steady but below trend. The key is whether global growth forecasts are revised upward, which would validate the sector rotation into capital-intensive industries. Conversely, a slowdown in global manufacturing or trade would challenge the earnings narrative and put pressure on valuations.

In summary, institutional investors should closely monitor three main catalysts: the technical trajectory of the US dollar, the breadth and persistence of institutional flows, and changes in global growth forecasts. Tracking these indicators will help determine whether the structural rotation into emerging markets is gaining traction or facing obstacles. At present, the evidence supports a strong case for continued investment, but vigilance is essential to navigate potential inflection points.