Ben Johnson, director of global ETF research for Morningstar, explains why the way that some of us approach emerging-markets investing may be outdated.
One myth is that somehow investing in emerging markets meant that you would be investing heavily in the commodities cycle.
I looked at the portfolio of the iShares MSCI Emerging Markets ETF through the lens of its evolution in terms of its sector exposures. If you go back to the prior bull market peak before the great financial crisis, what you saw was that the sector composition of the MSCI Emerging Markets Index skewed very heavily toward materials names, very heavily toward energy names. We were in the midst of a commodities boom. Subsequently, the boom has gone to bust, and emerging markets have begun to re-emerge, and very much so in 2017 when on a year-to-date basis we've seen them be the best-performing asset class among the major asset classes is that that sector composition has evolved dramatically.
Remember, we are talking about a market-capitalization-weighted index. Over time, as investors vote on the prospects of these economies, of the firms that operate in them, it will continue to evolve. It's a living, breathing organism.
Today, the largest sector within that same index is actually the technology sector.
The technology sector in emerging markets has been on a tear lately in much the same manner as it has been here in the United States. It's important not to think of emerging markets as in some way being sort of frozen in time in terms of your underlying exposure to different sectors and indeed different countries when it comes to investing in a market-capitalization-weighted index fund or really any fund whatsoever.
The growing importance of technology stocks in the emerging-markets index in some respects due to China's ascent.
What you've seen in recent years is not only an evolution in terms of the underlying sector exposure within this index but the underlying country exposures as well. If we go back to the days before the global financial crisis, what we saw was Brazil was at the top of the pile. Not coincidentally, the biggest names in Brazil, like Petrobras and Vale, were big materials and energy firms. Fast forward to today, and what you see is, China has been ascendant. Chinese stocks now represent over a quarter of this index's portfolio, and two of the tech behemoths--they call China home--Tencent and Alibaba are some of the best-performing stocks within the index's portfolio on a year-to-date basis.
Another idea that deserves revisiting is the correlations between the U.S. and emerging markets come closer together.
If you go back 30 years ago, the MSCI Emerging Markets as a group represented about 1% of the total market capitalization of global stock markets. You fast forward to today, and that's now almost 12%. A lot has happened over the course of the past 30 years. One very important event was the birth of this index itself. Once this index was born, once more and more investors began to recognize emerging markets as potentially being a standalone asset class, you saw their money follow. As more and more investors and foreign investors, in particular, have allocated money to this asset class, what you've seen is a structural shift in the level of correlation with U.S. stocks and other developed market international stock markets, whereby emerging markets increasingly are zigging and zagging alongside both U.S. and developed ex-U.S. stocks.
Also, more fundamentally, what you have seen aside from just more investment dollars being allocated is you've seen the footprint of a lot of firms in developed markets in particular expand into these same markets. If you look at an interesting suite of indexes, which is, MSCI's, in this case, USA Index with emerging-markets exposure, this index looks at U.S. stocks, stocks in the MSCI USA Index, and then weights them on the basis of their exposure by way of revenues to emerging markets. Now, the largest stock in that U.S. index is actually Apple. Apple derives a huge amount of their revenue from emerging markets. What it gets back to is just this fundamental shift in terms of the footprint of stocks they call, in Apple's case, Cupertino home, but are growing their businesses in all different geographies. It's important to remember that you are getting an inherent degree of diversification investing in your own backyard by virtue of the fact that many of the largest U.S. firms have expanded in a big way into emerging markets in particular.
This discussion initially appeared in morningstar.com
