Home-market bias remains one of the great inefficiencies in many portfolios. For example, even though almost half of all US-listed exchange-traded funds are dedicated to foreign stocks and bonds, some 67 per cent of their total assets are invested in US stocks and bonds.
There’s a relatively simple explanation: American investors are so accustomed to US technology companies dominating the world stage that we think owning Apple/Google/Amazon/Facebook is the same as a well-stamped passport in terms of exposure to international markets. Tech stocks are the single largest weighting in the S&P 500, after all, and they have worked well in 2017.
But the performance of emerging markets this year shows how this home-market bias is a lost opportunity. In dollar terms, the MSCI Emerging Markets Index is up 34 per cent, compared with 16 per cent for the S&P 500 Index. As it always does, capital has followed performance, with EM ETFs attracting $34 billion (Dh124.88 billion) in 2017.
How did EM become global market darlings? The answer is not in the old playbook of export-driven growth and rising middle-classes. The real driver of performance is one US investors will recognise quite readily.
The MSCI EM Index is remarkably tech-heavy, with a 29 per cent weighting, topping the S&P 500’s 25 per cent. To frame this level with some other indexes American investors know well, the Russell 2000’s weighting to technology is 17 per cent, which is on par with financials, and the Dow Jones Industrial Average’s 18 per cent exposure.
Another point to consider: EM tech stocks with the largest weightings in the index make large-capitalisation US tech stocks look downright slouchy, even though the hometown favourites are up an average 30 per cent in 2017. Here are the top five holdings in the MSCI EM Index with their year-to-date weightings and performance:
• Tencent Holdings (China): 5.1 per cent weighting. Up 99 per cent in local currency terms.
• Samsung Electronics (South Korea): 4.7 per cent weighting. Up 56 per cent in local currency terms.
• Alibaba Group (China, listed US): 4 per cent weighting. Up 113 per cent in dollar terms.
• Taiwan Semi (Taiwan, ADR in US): 3.7 per cent weighting. Up 48 per cent in dollar terms.
• Naspers Limited (South Africa). 1 per cent weighting. Up 76 per cent in local currency terms.
Despite these gains, EM valuations are still attractive, which is not something you can say — with a straight face, anyway — about US equities. Based on recent work by Lazard, EM price-to-earnings multiples stand at 12.6 times forward-year estimates, versus 18 times for the S&P 500. And while EM tech stocks trade at a premium of 14.5 times next year earnings, their expected earnings growth rate is greater than 20 per cent.
As much as EM is cheap and working, there are some notable risks. Here are three at the top of the list:
No. 1: The large-cap tech names we noted above have greater influence on the MSCI EM Index than Apple/Microsoft/Amazon/Google/Facebook have on the S&P 500. Total the weightings for the Big Five in EM, and you get 19.6 per cent.
That’s more than the 13.7 per cent for the big tech names in the S&P 500. Another way to look at this is that even though the MSCI EM Index has almost 1,000 members, just five essentially represent 20 per cent of the benchmark. Any problem with even one or two of these names could put a dent in overall performance.
No. 2: Financials make up the second-largest weighting in the MSCI EM Index, or 23 per cent. Add in the tech weighting and you’ve got greater than 50 per cent of the benchmark skewed to just two sectors. By comparison, the two largest sectors in the S&P 500 — tech and financials — account for just 40 per cent of that index, The same groups top the sector list for the Russell 2000, but only represent 34 per cent of the total.
No. 3: Well over half, or 56 per cent, of the MSCI EM Index is in just three countries: China (27.9 per cent), South Korea (15.6 per cent) and Taiwan (12.5 per cent). India (8.8 per cent) and Brazil (6.6 per cent) don’t even break into double-digit weightings. That puts the EM index squarely in the middle of the ongoing North Korea nuclear situation.
This geopolitical challenge is a far greater issue to the MSCI EM Index than its notionally diversified name would imply.
EM assets looks compelling even after this year’s rally. They are still relatively cheap, the global economy looks decent, and they have their share of home-grown tech sector leadership.
Yes, the tech sector concentration risk is an issue, but the way US stocks are working, we may soon have the same problem with those stocks as well.
