Emerging market (EM) mutual funds are proving increasingly attractive to U.S. investors. Recent quarterly returns have been high; prospects for future gains are bullish; and, if well-chosen, they can offer solid diversification from U.S. and developed market stocks.
But before investors pour money into EM stock funds, they should do at least a little homework, or they might not get what they expect. Poorly chosen funds can create as many problems within a portfolio as they solve. The real long-term opportunity in emerging markets goes beyond following cap-weighted indexes.
The MSCI Emerging Markets Index, the leading gauge of EM equities, consists of 24 countries. Yet the stocks of only three countries — China, South Korea and Taiwan — comprise 56% of the index. Nearly 12% is in a handful of Chinese technology stocks.
On the bright side, in the most recent quarter, the MSCI EM Index rose 8%. China, which makes up roughly 29% of the index, accounted for over 50% of the quarter’s gains. Three China-domiciled information technology giants (TenCent, Alibaba and Baidu) accounted for over 25% of overall gains. That is impressive outperformance.
Do these stocks have further potential for strong gains? It’s possible. But does the weight in the index of the Chinese tech sector expose investors to significant concentration risk? Absolutely.
Many recall that in the U.S. in the 1990s, technology stocks soared from five percent of the Nasdaq Composite index way up to 25 percent. What is less remembered is the same thing happened in emerging markets from 1997 through 1999. Anyone remember what happened next?
Right: the bubbles burst, and the sectors collapsed.
History does not repeat, but it often rhymes.