Emerging markets, such as China and India, are at the head of global growth. They are increasingly prosperous and tech-astute populations, that are home to some of the world’s most cutting-edge companies.
The aim of this article it to provide a better understanding of some of the fundamental characteristics of emerging market funds, and why we include them in a well-diversified investment portfolio.
Market capitalization bias
The range of company size in the MSCI Emerging Markets Index ranges from ‘small caps’ through to ‘mega caps’. Mega cap companies comprise 54.4% of the index, large cap 34.3%, midcap 9.2% and small cap 0.3%. The top ten stocks in the index comprise 24% of the index.
The market capitalization of ‘active’ emerging market fund managers can vary but they have a tendency to invest in mega and large cap companies, such as Taiwan Semiconductor, Samsung, Tencent, Alibaba & NVIDIA.
Country bias
The exposure to countries in the MSCI Emerging Markets Index is even more concentrated with the top four countries comprising 73% of the index. China has the greatest allocation with 24.7%, followed by India with 17.7%, Taiwan with 17.5% and South Korea with 12.9%. A fund’s performance can be affected by the country to which a particular fund is biased.
Number of stocks held in the portfolio
Emerging market funds may also vary in the number of stocks held. This can vary from a highly concentrated portfolio of between 30 and 80 stocks to a highly diversified portfolio of between 1300 – 1400 stocks. The greater the concentration of the portfolio the more volatile a fund’s performance can be.
Active versus passive
As noted above, emerging markets have a small investable universe and a concentration of countries. For that reason, active fund managers can add excess or ‘alpha’ returns above the benchmark, and within a portfolio. Since July 2017, comparing a few active funds to passive, the active funds have had excess returns of between 1% – 8% p.a.
Tracking error
Emerging market funds will track an underlying benchmark, the most common being the MSCI Emerging Markets Index. Tracking error measures the volatility of excess returns of a fund or portfolio relative to an index. Funds with a high tracking error may underperform or outperform the market significantly over extended periods of time. They are therefore ‘riskier’ than less ‘active funds.’ Index or passive managers have a very low tracking error.
‘Active’ emerging market funds tend to have a tracking error between 5% – 10%.
Correlation/diversification
Correlation shows the strength of a relationship between two securities and is expressed as a value between -1.0 and 1.0. A perfect positive correlation means that the correlation is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation of -1 means that two assets move in opposite directions, while a zero correlation implies no linear relationship at all.
Emerging market funds have a low correlation to uncorrelated relationship with the S&P/ASX 200 and the S&P 500 ranging between 0.1 to 0.6. This indicates that emerging markets can provide diversification benefits, when added to a portfolio.
Growth and income
The distribution of emerging market funds, in contrast to Australian share funds, is likely to be much smaller generally ranging from 2.5% – 3.5% p.a. However, should markets fall, and realised capital losses exceed capital gains their distributions can be reduced close to zero.
Emerging markets tend to be more reliant on growth for total performance return.
Written by
Michael Simmons
Financial Planner