Emerging Markets: The Cost of Weighting

Written by: Global Thought Leadership | November 10, 2017

Source: Bloomberg and Legg Mason,11/9/17. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The Bottom Line

  • Emerging Market (EM) stocks have been drawing attention recently; the combination of improving fundamentals, attractive valuations and strong performance stands out in the context of a U.S. equity bull market that has set records for longevity.
  • The temptation for investors new to this part of the market is to gain exposure to these positive prospects through passive strategies – in the hope of buying the entire sector through one of a variety of well-established indexes.
  • But despite the care with which these passive indexes are designed, most share the problem of being more or less based on the relative amount of stock available for investment in each country.
  • Underlying this otherwise sensible is a capitalization-weighted structure, where the largest stocks have greater weight than others.
  • This results in a problematic skew in the direction of the countries with the largest equity markets. For example, China and South Korea together make up close to half of the MSCI Emerging Market Index,1 while Brazil and India comprise 8.6% and 7.0% respectively.
  • The result: a passive investment in EM could very well have strong country biases that represent neither the prospects for those countries’ stock market, nor the informed preferences of an investor focused on those particular countries – to say nothing of environmental, social and governance (ESG) considerations.
  • All of which strongly suggests that both the opportunities in EM investing and the well-understood inefficiencies of many of these markets can best accessed through an active, discriminating investment manager   – rather than by an index which is both mechanical and inherently backward-looking.

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IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.