Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Emerging markets have staged a strong recovery so far in 2017, but investors had to endure a long, painful slog prior to that. Joining me discuss some key myths surrounding emerging-markets investing is Ben Johnson. He is director of global ETF research for Morningstar.
Ben, thank you so much for being here.
Ben Johnson: Thanks for having me, Christine.
Benz: Ben, you wrote about emerging-markets investing in the latest issue of ETFInvestor. The article was really thought-provoking because you took a look at some of the conventional wisdom around emerging-markets investing and you used current data to show that some of the ways that some of us approach emerging-markets investing may be outdated. Let's start with some of the myths that you shattered in this article. One--and I think this is one that I was carrying around in my mind--was that somehow investing in emerging markets meant that you would be investing heavily in the commodities cycle. Let's talk about why that idea needs revisiting.
Johnson: That idea needs revising because if you look at emerging markets through the lens of the MSCI Emerging Markets Index and those funds that track that index. So, in the context of my research, what I did is, I looked at the evolution of the portfolio of the iShares MSCI Emerging Markets ETF and looked at it through a variety of lenses.
First, what I did, was I looked at it through the lens of its evolution in terms of its sector exposures. Now, 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. What you've seen subsequently is that boom has gone to bust, and emerging markets have begun to, as you alluded 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. Fast forward to today, and what you see is that 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.
Benz: The growing importance of technology stocks in the emerging-markets index, that's in some respects due to China's ascent, right?
Johnson: Absolutely. 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.
Benz: Industry exposure is changing, country exposure is changing. One thing some people think about when they add emerging markets to a portfolio is that it is going to add diversification. If I, say, have a core U.S. equity position that perhaps if I add emerging markets, I might get stocks that would be moving in a different performance pattern. You say that that is another idea that deserves revisiting because we've actually seen correlations come closer together.
Johnson: 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.
Benz: That's an interesting point. Another thing, and you mentioned this idea of investors approaching emerging markets assuming that they need sort of a standalone holding in emerging markets. Let's talk about that. I know some advisors and investors think that that's a way to approach emerging markets. But is that necessarily? Or could I perhaps invest in a broadly diversified foreign stock fund and get ample emerging markets there as well?
Johnson: That's absolutely the case. Again, if you look at the total, sort of, world equity market capitalization, so the MSCI All Country World Index, emerging markets make up about 12% or so of that index. Assuming a hypothetical balanced portfolio that allocates 60% to stocks, global portfolio stocks, 40% to bonds, emerging markets at market weight make up about 7% of your portfolio. You can get that exposure at market weight by simply owning an index fund that's tied to the All Country World Index. You can get it by owning an ex-U.S. Index, ACWI Ex-U.S. Index. There are a variety of ways above and beyond those that I already mentioned, which may already exist without your knowing it, to get exposure to growth in emerging markets without necessarily owning those stocks as a standalone sleeve in your portfolio within your asset allocation.
Benz: I suppose one advantage though to having that standalone allocation is, as you've mentioned, emerging markets can be really volatile, and they are subject to these boom/bust cycles. I guess, one advantage of having that standalone position is that I would have some discretion if emerging markets went through a long, dark night like they did prior to 2017, that I might have the opportunity to top up that position and give it a little more of a boost if I think emerging markets are cheap?
Johnson: That's absolutely the case. If you are so inclined to manage that on a standalone basis, to make some sort of call to voice some sort of opinion on either relative valuations or momentum within a given market, that's absolutely something that you can do. There is an expansive menu of different funds, index funds and ETFs in particular, that slice and dice this segment of the market in a variety of different ways.
Benz: OK, Ben. Great research. Really fascinating insights into emerging markets. Thank you so much for being here.
Johnson: Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.