Misleading Emerging Markets Funds

Misleading Emerging Markets Funds

Do you know why most emerging markets funds outperformed US markets in 2017? It is not, as popularly believed, because of the impressive ~50% growth in emerging markets’ stock market indices like Argentina, Nigeria, and Poland– these countries combined are just over 1% of MSCI Emerging Market (EM) indices.1, 2 

Emerging markets outperformed because two of the funds’ biggest holdings, Tencent and Alibaba which constitute 10% of MSCI’s EM index, were up 113% and 97% respectively. 3, 4 Emerging markets outperformed because the benchmarks have been reconstructed to be an amalgam of Asian tech stocks instead of a broad representation of emerging market stocks.

The MSCI Emerging Markets index, which is the benchmark for over $1.6 trillion in assets for both active mutual funds and passive ETFs, is misleading because:5

1 ) Asia is over 70% of the index, belittling the representation of other regions of the world;6

2) South Korea and Taiwan are over 25% of the EM index, even though the International Monetary Fund considers these to be advanced economies;7, 8

3) The index is composed of a basket of idiosyncratic stocks, not aggregated country indices;

4) Tech stocks are 27% of the MSCI EM index vs. 14% of the MSCI All-World Index. This tech dominance does not necessarily represent the region’s indices — the iShares Large-Cap China ETF (FXI) is just 9% technology but 50% financials, 10% real estate, and 9% energy.9

MSCI has changed its methodology based on “free-float market cap” which has resulted in the following oddities:

A) Tencent and Alibaba have a higher weighting than all of India, which has over 1.3 billion people, and is the world’s 6th largest economy with $2.3 trillion annual GDP per the IMF. 10

B) Tencent is double the weighting of all of Russia, an economy with $1.3 trillion GDP.11

C) Brazil has a higher GDP and 4X the amount of people as S. Korea but is just 1/2 its weight.12

D) Mexico, Indonesia, Nigeria, and Turkey with over $3 trillion in GDP and 640 million people13 are given less weight than Tencent, a Chinese tech company with $28 billion in annual revenues and a $540 market cap.14

Even if you believe in the potential of Chinese tech stocks, as I do, investors and clients should better understand the massive Asian technology exposure they are taking when investing in what they may believe is a more global and diversified Emerging Markets fund. Standard and Poor’s and FTSE also have created benchmarks for emerging markets which are similar to that of MSCI, with a few differences that make them a tad more representative, in my opinion.  Conversely, if a client wants to invest heavily in Asian tech stocks, there are ways to invest more directly in these stocks and sectors. 

If the point of EM index and mutual fund investing is to diversify away single stock risk and approximate EM underlying growth, EM funds that are based on these benchmarks don’t seem to fit this goal. 

Financial advisors, robo-advisor programs, and retirement plan administrators should be aware of these discrepancies and inform and advise their clients accordingly.  Caveat emptor.