With U.S. equity markets suddenly correcting, many investors are weighing investments in emerging markets (EM) – for potential returns, and diversification. Both are possible.
BUT: When investing in any EM equity ETF, it is important to know the components. Why?
The MSCI Emerging Markets Index, the most popular EM benchmark, has a potential investment universe of 24 countries, 11 sectors and more than 800 stocks. Yet, as of December 31, 2017:
- Nearly 60 percent is allocated to three countries: China, South Korea and Taiwan.
- Over 50 percent is allocated to two sectors: information technology and financials.
- Five stocks comprise roughly 20 percent: Tencent Holdings Ltd. (China), Taiwan Semiconductor Manufacturing Company (Taiwan), Alibaba Group Holding Ltd. (China), Samsung Electronics Co. (South Korea), Naspers Limited (South Africa).
Today, China, Taiwan and South Korea have the highest correlation to developed markets, including the U.S. This is just one example that funds that hug the MSCI EM benchmark aren’t always diversifiers.
IT and financial stocks are generally cyclical, growth-oriented and large-cap dominated, with all those biases.
Moreover, rising stocks in countries and sectors not favored in the index can be big missed opportunities.
As over-concentrated country or sector “bubbles” deflate, they can cause significant drawdowns. These losses often take time to recover from and can drive investors away from the markets.