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Emerging Markets: Opportunities Abound, but Beware the Index

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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.

If investors want to invest heavily in Chinese tech stocks, we recommend they purchase funds after careful research. That way they can be sure of what they are buying. If they want to invest in the larger EM sector, however, they should seek funds that offer broader diversification of risk as well as return opportunities.

The case for investing in emerging market stocks is compelling. With the exceptions of Qatar, Greece and Pakistan, every country in the MSCI EM Index realized positive gains last quarter. The International Monetary Fund projects that emerging markets will grow twice as fast, if not more (with possible 5% increases in real annual GDP), than the advanced economies of the U.S., U.K. and Europe (with expected GDP growth around 2%).

EM equity gains are also being driven by stabilized commodity prices. This benefits users and producer nations, providing a more stable economic backdrop for EM countries and companies that operate there. Since the Taper Tantrum of 2013, EM countries have repaired their balance sheets. As a result, they are enjoying rosier economic prospects and improving fundamentals.

Political reforms in countries like Brazil and Argentina are bolstering confidence in their markets, while current account deficits have fallen significantly. EM countries also should benefit from increasing productivity enhancements as more capital investments take hold.

Equity valuations also favor emerging markets, which have recently traded at a price-to-earnings discount of more than 20% to advanced economies. On a forward basis, that discount is intact.

We believe EM equities have room to run, and they should be part of an investor’s overall growth allocation. Yet investors who want to tap the potential of emerging markets must first understand what they own, to ensure they can receive the true benefits EM investing offers.

By owning the common passive EM equity strategies, investors could be exposed to far more risk than they realize. Concentration in a handful of high-flying Chinese tech stocks could bring exceptional returns — unless they stumble and drag the whole index down with them. Investors in these passive funds may have far less access to the growth potential of smaller emerging markets, and they might not receive the diversification benefits they were expecting.

The challenge for investment managers is helping our clients participate in the growth potential of emerging markets, while avoiding the many pitfalls blindly investing in developing markets can bring. It is not always easy — and it takes experience, commitment and focus — but well-chosen EM investments can often help informed investors meet their long-term investment goals, with fewer bumps on the way.