Emerging markets and ETFs

If you haven’t come across the term ‘emerging markets’ before, it’s natural to imagine that they are made up of lots of hidden gems in the form of little-known companies in small countries. But that’s far from the truth. A quick look at the composition of some of the most well-known and actively traded emerging market ETFs shows this up in stark relief. For example, among the top holdings in the iShares MSCI Emerging Markets ETF are the Taiwan Semiconductor Manufacturing Company with a 6.6% weighting in the index, China’s Tencent Holdings (3.9% weighting), South Korea’s Samsung Electronics (3.8%), and China’s Alibaba Group Holdings (2.6%). Other well-known companies with significant weighting within the ETF include India’s Infosys and the China Construction Bank Corporation (both 1% of the ETF). As you can see, these constituents are large conglomerates which should be on the investment radar of any fund manager looking outside the US, UK, and Europe. That’s not to say that this ETF isn’t diversified. After all, it has 1,339 constituents. But Chinese companies make up the biggest share of the index at 30%. Taiwanese companies come in next at 16.2% with Indian corporations in third place with 13.1%.  As you can see, it’s important to consider the concentration of constituents, and not only by country, but also by sector. For instance, are you happy with an ETF with a large exposure to the tech sector? Perhaps the biggest and most actively traded emerging market ETF is the Vanguard FTSE Emerging Markets ETF. It holds over 5,200 stocks from across the world. Despite this, it has been criticised for its concentration around big names with the fund's 10 largest holdings accounting for about 24% of the portfolio's weight. In addition, around 30% of the fund is dedicated to technology. These are all factors which are important to consider when choosing an ETF. Fortunately, there is a fair amount of choice out there and hopefully you can find an emerging market ETF that will suit your investment needs. It’s worth noting, for example, that iShares also has an ETF which excludes China.

Performance and China

So, that’s a bit about the ETFs, but what about the performance of emerging markets themselves? Since the nadir of the Great Financial Crisis in March 2009, the S&P 500 has significantly outperformed the MSCI Emerging Markets ETF. Could that be about to change? Some analysts believe that it’s time for emerging markets to burst back to life, but others are less sure. It’s worth noting that emerging market ETFs have been hit by the US tech-led sell-off since the end of last year. So far this year the MSCI Emerging Markets ETF has lost over 22% from its high in early January to the recent low. The S&P 500 fell just under 20% in the same period. So, there’s not much in it. Indeed, many of the main emerging market ETFs look relatively cheap when compared to the US majors. But while some analysts point to an attractive valuation for the MSCI ETF relative to the S&P, there’s the threat of greater volatility with emerging markets. When investors want to raise money, they have a propensity to come out of their riskier and most volatile holdings first, and that means emerging markets. While many may be surprised that the world’s second largest economy is still labelled an emerging market, as we’ve seen, many emerging market indices have a high exposure to China. This is a major cause of emerging market underperformance. China has been a problem for investors for many years and remains a worry. First there were the Trump trade wars, then China’s growing belligerence over Hong Kong and other human rights abuses. Then we had China’s crackdown on tech companies.  Now there’s Covid, as China’s poor vaccination record (and poor vaccines) and its lockdown response appear to have failed.

Growth differentials

Inflation is often a major concern, particularly in smaller emerging market countries. We have seen examples where holding certain equities can help offset inflationary pressures. But these holdings must be specific, rather than general. After all, tech stocks have been hit hard, while consumer staples have held up relatively well. But when developed-world countries are looking at stagnant rates of economic growth, smaller and nimbler emerging markets may seem attractive. The trouble is that many investors are anxious to avoid too much exposure to China. Others point out that the world has changed dramatically since the beginning of this century, and it seems unlikely that history will repeat whereby we see smaller countries achieve growth rates that far outstrip those of the US. As far as most US-focussed investors are concerned, they get enough international exposure by owning an index fund on the S&P 500.