It's important for investors to consider the inherent concentration risks that may be embedded in their equity portfolios -- including their emerging markets allocation.
Global equity markets moved seamlessly into 2018, with performance arguably stronger than what had already been an outstanding 2017, propelled by synchronized global economic expansion. The recent rally was abruptly interrupted during the last days of January as all major equity indices declined sharply driven by expectations of rising inflation as economic growth accelerates and higher government yields as the 10-year US treasury the highest level since January 2014. While a few days may not set a trend, they are a reminder of the implications of an aging expansionary market.
- Building Concentration Risk: With nearly 60% of the MSCI Emerging Markets (EM) Index allocated to three countries (China, South Korea and Taiwan) and over 50% to two cyclical growth oriented sectors (Information Technology and Financials), it is important for investors to consider the inherent concentration risks that may be embedded in their equity portfolios
- Mispricing of Risk: Given we have realized the longest bull market in US history, we believe that now is the right time to consider whether risk is being accurately priced into the market. We believe that measuring risk may be harder now given the extended low volatility environment we have been in
A cautionary tale
The MSCI EM Index comprises over 800 stocks, 11 sectors and 24 countries. In spite of its apparent breadth, the MSCI EM Index has become one of the most concentrated benchmarks; as only a handful of stocks, sectors and countries drive most of its performance.
Furthermore, stellar performance of large cap, Technology and Chinese stocks during 2017 and early 2018 have further exacerbated this concentration.
- Five stocks in the MSCI EM Index have 20% of the weight, two sectors have 51% of the weight and three countries have 56% of the weight.
- 822 stocks in the MSCI EM Index have 0.5% or less weight, and five sectors and 18 countries have less than 5% weight.
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.
Composition of MSCI EM Index as of February 5, 2018
Source: FactSet and MSCI. *The five largest stocks in the MSCI EM Index are Tencent Holdings Ltd. (China) (5.1%), Taiwan Semiconductor Manufacturing Company (Taiwan) (3.7%), Alibaba Group Holding Ltd. (China) (3.7%), Samsung Electronics Co. (South Korea) (3.7%), and Naspers Limited (South Africa) (2.1%).
The Technology sector and China are at historically high weights in the MSCI EM Index, 28% and 25%, respectively, and the addition of China A shares to the index, starting in June 2018 with approximately 222 stocks or 0.7% of the MSCI EM, will likely further increase the weight of China.
While China and the Information Technology sector have delivered significant growth thus far, we believe it can be difficult to predict how long this growth will persist and which opportunities will end up being the next top performers. It is important for investors to consider the risks embedded in the MSCI EM Index, as well as the potential for missed opportunities.
Over time we have seen that as country or sector bubbles deflate, their weights can inflict damage on broader indexes, causing significant drawdowns.
Bubbles and busts: Sector weight at the peak and end of past bubbles, and cumulative losses during those episodes
Sources: Bloomberg, MSCI, Standard and Poor’s. Past performance is no guarantee of future results. All returns are cumulative rather than annualized, and calculated on a monthly basis. Market indexes for each sector are Japan: MSCI EAFE; S&P 500 Info Tech, Financials and Energy: S&P 500. All index and sector returns reflect price appreciation/depreciation; returns due to dividends are excluded. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
With these swings in mind, our Diversified-Based Investing (DBI) EM investment strategy seeks to provide truly diversified exposure to a broad set of return drivers in emerging markets, with more balanced sector and country weights than the market-cap benchmark; we identify 10 macroeconomic emerging market return drivers which exhibit a low correlation to one another, we then weight each of these drivers equally within the portfolio.