As investors add more exchange traded funds, it is important to look under the hood and consider sector and company exposures to properly maintain a well-diversified investment portfolio.
Investors are showing more interest in international equities, notably the relatively cheap emerging markets, but investors should first consider what they are getting themselves into.
“It’s important for investors to consider the inherent concentration risks that may be embedded in their equity portfolios – including their emerging markets allocation,” Michael J. LaBella, Portfolio Manager for QS Investor, an affiliate of Legg Mason, said in a research note.
Financial advisors can also learn more about Legg Mason’s insights at the upcoming virtual conference. On March 14, 2018, ETF Trends will be hosting its annual Virtual Summit, an online virtual conference environment where financial advisors can learn about current ETF issues, hear from industry experts and connect with peers without the burden of cost and traveling.
2018 ETF Trends Virtual Summit returns Wednesday, March 14! Earn 5 CE Credit – click to register!
LaBella pointed out that nearly 60% of the benchmark market capitalization-weighted MSCI Emerging Markets Index is focused on China, South Korea and Taiwan, with over 50% of the portfolio leaning toward cyclical growth sectors information technology and financials.
“It is important for investors to consider the inherent concentration risks that may be embedded in their equity portfolios,” LaBella said.
These traditional market-cap weighted indices expose investors to significant risks, especially after the recent run up in technology stocks, which may leave investors exposed to some of the more pricey segments of the emerging market.
“In our view, this over-concentration not only leaves investors reliant on a handful of return drivers but diminishes the portfolio diversification benefits an emerging markets allocation looks to provide versus developed markets. Compared to lower-weighted countries in the index, China, Taiwan and South Korea, realize the highest correlation to developed markets such as the US,” LaBella said.
Alternatively, investors seeking emerging market exposure may consider a smart beta play that follows an alternative index weighting methodology. For instance, the Legg Mason Emerging Markets Diversified Core ETF (NasdaqGM: EDBI) through a partnership with QS Investors breaks down the universe of securities into investment categories based on sectors and countries.
2018 ETF Trends Virtual Summit returns Wednesday, March 14! Earn 5 CE Credit – click to register!
The five-year return patterns of the countries and sectors are taken to uncover relationships – areas that behave alike or differently. The underlying index then combines investment categories with more highly correlated historical performance into smaller number of so-called clusters, which are categorized based on tendency to behave similarly, or show various correlations. Each of these clusters are then equally weighted individually and also equally weighted across the portfolio to produce a diversified investment strategy.
The result is an emerging market ETF with a more balanced allocation across macro drivers. Specifically, among its top country and sector weights.
For information on the developing economies, visit our emerging markets category.