FA Center: Adding emerging markets to your stock portfolio is tougher than it looks

Is South Korea a “developed” or “emerging” stock market? Most investors haven’t thought about this question, but a lot is riding on the answer.

FTSE Russell, one of the world’s leading index providers, considers South Korea’s stock market to be in the developed category. Rival MSCI puts that country’s market into the “emerging” category.

Welcome to the surprisingly complex world of asset allocation. Many investors are surprised to learn of this disagreement about how to classify South Korea. Investors have assumed that the “emerging market equity” category is well defined, both in terms of which countries are included and also how the category differs from others.

The category is anything but. In fact, there isn’t even consensus among researchers that “emerging market equities” deserves to be a separate asset class. How can you decide what to allocate to an asset class when it’s unclear what it contains?

Here’s another difficult question: Is China’s stock market developed or emerging? Consider that China’s economy is the second-largest in the world, with a share of global GDP that is only slightly behind that of the U.S. And, yet, both FTSE Russell and MSCI put China’s stock market in the “emerging market equities” category, along with Egypt, Peru and Turkey. (FTSE Russell and MSCI classify China in this way because of the country’s capital controls and other restrictions that prevent its stock market from being fully integrated into the world market.)

My point in raising these issues is not to suggest that there is a better way to categorize countries than what FTSE Russell or MSCI have come up with. My goal instead is to remind us that categorization is a messy business. We forget that messiness when we focus only on index funds and ETFs that are benchmarked to those categories, overlooking the wide variability in the performance of their individual components.

What is an asset class, anyway?

When this variability is especially wide — as is the case with the emerging market equities category — then one wonders if each of its components really belongs with the others. It’s not clear, for example, that the same factors impact the returns of countries as diverse as China, the Czech Republic, and United Arab Emirates. Yet they are classified as emerging markets.

Take the range of stock-market returns in 2017 among the various countries in the category. The highest return, in U.S. dollar terms, was Poland, gaining 52.2% (according to MSCI). At the other end of the extreme was Pakistan, with a loss of 28.1%. (See accompanying chart.) This wide spread of more than 80 percentage points is one reason why some question whether the emerging market equities grouping constitutes a coherent category.

Campbell Harvey, a finance professor at Duke University, said in an interview that this wide range of returns is not a good reason to conclude that emerging market equities is not a distinct asset class, however. He points out that there is just as wide a range, if not more, among individual commodities, and yet investors don’t seem to have much issue calling “commodities” a distinct asset class.

The best performing commodity in 2017, in U.S. dollar terms, was aluminum, with a 56.3% return. The worst was zinc, which posted a 20.7% loss. The resultant spread of 77 percentage points is almost as big as in the case of emerging market equities.

How to think about emerging market equities

Perhaps the best way to focus your thinking on emerging market equities is to ask whether you want to allocate more or less to the category than its proportional share of the total market capitalization of the world’s stock markets.

Currently, for example, South Korean stocks represent about 2% of the world’s GDP. If you invest in an index fund benchmarked to the world’s stock market (such as the iShares MSCI ACWI ETF ACWI, +2.02%  , you will automatically (if implicitly) be investing 2% of your portfolio in South Korean stocks. No asset allocation decision is needed.

If you want to deviate from market weights, then you need to pay attention to which countries’ markets are included and excluded. Indeed, some well-known investment managers currently believe that investors should overweight emerging market equities. GMO, for example, the Boston-based money management firm, argues that emerging market stocks, and especially so-called “value” stocks in emerging markets, “represent the most attractive asset we can find by a large margin.”

Another rationale for overweighting emerging market equities comes from Duke’s Harvey and Geert Bekaert, a finance professor at Columbia University. A recent study they co-authored pointed out that while emerging market equities currently represent about 15% of the world’s total stock-market capitalization, emerging market countries’ share of world GDP is more than 30%. The researchers believe that these two numbers will at least partially converge over time, and that at least some of the merging will be the result of “valuation convergence.” If so, then emerging markets equities could produce explosive performance in coming years.

For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com .

Related: ‘If you can’t beat the market, how did Warren Buffett do it?’ and other awkward questions for your financial adviser

Also read: Here’s how much U.S. stocks are lifting the global market, in one chart

Want news about Asia delivered to your inbox? Subscribe to MarketWatch's free Asia Daily newsletter. Sign up here.

Be Sociable, Share!

Related Posts


MarketTamer is not an investment advisor and is not registered with the U.S. Securities and Exchange Commission or the Financial Industry Regulatory Authority. Further, owners, employees, agents or representatives of MarketTamer are not acting as investment advisors and might not be registered with the U.S. Securities and Exchange Commission or the Financial Industry Regulatory.

This company makes no representations or warranties concerning the products, practices or procedures of any company or entity mentioned or recommended in this email, and makes no representations or warranties concerning said company or entity’s compliance with applicable laws and regulations, including, but not limited to, regulations promulgated by the SEC or the CFTC. The sender of this email may receive a portion of the proceeds from the sale of any products or services offered by a company or entity mentioned or recommended in this email. The recipient of this email assumes responsibility for conducting its own due diligence on the aforementioned company or entity and assumes full responsibility, and releases the sender from liability, for any purchase or order made from any company or entity mentioned or recommended in this email.

The content on any of MarketTamer websites, products or communication is for educational purposes only. Nothing in its products, services, or communications shall be construed as a solicitation and/or recommendation to buy or sell a security. Trading stocks, options and other securities involves risk. The risk of loss in trading securities can be substantial. The risk involved with trading stocks, options and other securities is not suitable for all investors. Prior to buying or selling an option, an investor must evaluate his/her own personal financial situation and consider all relevant risk factors. See: Characteristics and Risks of Standardized Options. The www.MarketTamer.com educational training program and software services are provided to improve financial understanding.

The information presented in this site is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. Nothing in our research constitutes legal, accounting or tax advice or individually tailored investment advice. Our research is prepared for general circulation and has been prepared without regard to the individual financial circumstances and objectives of persons who receive or obtain access to it. Our research is based on sources that we believe to be reliable. However, we do not make any representation or warranty, expressed or implied, as to the accuracy of our research, the completeness, or correctness or make any guarantee or other promise as to any results that may be obtained from using our research. To the maximum extent permitted by law, neither we, any of our affiliates, nor any other person, shall have any liability whatsoever to any person for any loss or expense, whether direct, indirect, consequential, incidental or otherwise, arising from or relating in any way to any use of or reliance on our research or the information contained therein. Some discussions contain forward looking statements which are based on current expectations and differences can be expected. All of our research, including the estimates, opinions and information contained therein, reflects our judgment as of the publication or other dissemination date of the research and is subject to change without notice. Further, we expressly disclaim any responsibility to update such research. Investing involves substantial risk. Past performance is not a guarantee of future results, and a loss of original capital may occur. No one receiving or accessing our research should make any investment decision without first consulting his or her own personal financial advisor and conducting his or her own research and due diligence, including carefully reviewing any applicable prospectuses, press releases, reports and other public filings of the issuer of any securities being considered. None of the information presented should be construed as an offer to sell or buy any particular security. As always, use your best judgment when investing.