A passive approach to emerging markets gives investors a 56% weighting to three countries. James Norman makes the case for a more diversified approach.
With emerging market equities enjoying a strong 2017, a lot of investors have been asking me if there’s room for additional growth and performance in Emerging Markets (EM). Judging by all of the data we look at, the answer is a resounding: “It depends.” Do we see potential for on-going growth in EM? Absolutely. But will investors be able to capture the potential performance and portfolio diversification benefits of EM? Not if they continue to tap EM equities the old fashioned way – through the larger passive strategies that, by composition, no longer reflect the actual opportunity presented by EM but instead present greater access to risk.
Indicators Show Growth
To get a sense of the opportunity that EM still presents, we looked at global IMF data on forecasted real GDP growth from 2017 to 2019. The data shows that advanced economies, including the US, Europe and the UK, are expected to average around 2% real growth per year. By contrast, the emerging markets are expected to grow more than twice as fast as advanced economies, approaching up to 5% growth per year over the next few years.
Why? A convergence of positive factors including stabilized commodity prices that benefit both users and producer nations, providing a more stable economic backdrop for EM countries and the companies that operate there. Further, since the Taper Tantrum, EM countries have repaired their balance sheets and are enjoying improved economic prospects; and improving fundamentals. Political reform in countries like Brazil and Argentina are further bolstering confidence in the markets; while current account deficits have reduced significantly. Finally, we believe EM countries will benefit from increasing productivity enhancements as more capital investments take hold.
Valuations also favor EM. In fact, EM was recently trading at a P/E discount of more than 20% to advanced economies, and on a forward basis that discount is intact.
All of this points to a fertile environment for continued emerging market growth, and at a rate faster than advanced economies. The question is: How should investors approach EM equities investing going forward?
Know What You Own
Investors should remember that EM investing provides two key benefits – the possibility of meaningful returns, but as importantly, EM investing should provide portfolio diversification since the asset class, in general, is non-correlated to developed markets.
Unfortunately, one of the most common EM equity investments, the largest passive index, fails to give investors full access to potential growth, and instead it exposes investors to an overweight of risk while also being far more correlated to developed nations than most investors realize.
Did you know that 56% of the country weighting of the index is concentrated in just three markets: China, Korea and Taiwan? That means only 44% covers 21 other emerging market countries – countries that have enjoyed robust growth, but make a smaller dent in performance, because of their overall lower weighting in the index.
Not only does this massive overweight expose investors to significant risk should any (all?) of those three countries stumble, but these three countries have characteristics that are similar to developed nations, which means they are more correlated to the US and Europe. Given their significant over-weight, they defeat the benefit of diversification that EM should provide.
We believe emerging markets have room to run, and should be part of an investor’s overall growth allocation. But investors who want to tap the potential of emerging market equities need to understand what they own and make sure they are receiving the true benefits that EM has to offer. By owning the common passive EM equity strategies, investors could be exposed to far more risk than they realize. They may have far less access to the growth potential of smaller emerging markets. And they might not receive the diversification benefits they were expecting.
IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results.
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.
Diversification does not guarantee a profit or protect against loss.
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.