China is a significant part of the emerging market equities index. Disciplined portfolio diversification and balance may help mitigate risk exposures.
Strong investment performance requires balanced risk management through market cycles. But benchmark-relative risk can become a real challenge when benchmarks become top-heavy, either by sector or, depending on the benchmark, geography.
While much is made of the predominance of mega-cap tech stocks in U.S. equity benchmarks, an equal, if not greater, challenge is managing the predominance of both tech and China in the MSCI Emerging Markets Index. Information Technology is 28% of the S&P 500 Index, and upwards of 40% including tech-related names in Consumer Discretionary (say, Amazon) and in Communication Services (Google parent Alphabet, Facebook and Netflix).
Information Technology comprises 19% of the MSCI Emerging Markets (EM) Index, while Consumer Discretionary makes up 20% and Communication Services nearly 13%. But the tech-related names in the latter two sectors are led by mega-cap e-commerce and payments giant Alibaba Group, food delivery and online shopping platform Meituan Dianping and social networking and gaming platform Tencent Holdings, all three of which are Chinese. In fact, while tech and tech-related names in the index also approach nearly 40% of the EM benchmark, on a geographic basis China alone accounts for 42% of the bench, which groups large- and mid-cap stocks from 26 emerging markets.
Weight Watchers: MSCI Emerging Markets Index
Source: MSCI
A question we often get is a whether investing in emerging markets is effectively a bet on China and its more than 400 million middle-class consumers. To degrees it is, and perhaps should be. According to the International Monetary Fund, China, which grew 4.9% in the third quarter from the year before as it rebounded from the coronavirus pandemic, drives about one-third of global GDP growth. Based on purchasing power parity, China’s share of global GDP is nearly 20%, while almost 14% of global exports come from the Middle Kingdom.
China’s domestic market capitalization on the key exchanges in Shanghai and Shenzhen amounts to $10.7 trillion. Publicly listed Chinese companies onshore, in Hong Kong, the U.S. and Europe number about 4,900. Many are having a great year. After the Nasdaq Composite Index, China’s CSI 300 Index is the world’s best performing major equity benchmark with a 15% return by late October, lifting the broader emerging markets index to a 4% gain.
Thornburg Portfolio Manager Charlie Wilson, who runs the firm’s emerging markets strategies, fields questions on managing concentrated exposures to both tech and China.
Portfolio Diversification for Emerging Markets
Q: How do you think about portfolio diversification by geography when China represents more than two-fifths of the index?
CW: We don’t start with the benchmark when we construct our portfolio. First, we identify the strongest companies operating in emerging markets and wait for them to present themselves at an attractive valuation. The good and the bad news of emerging markets is that almost all stocks will disconnect from underlying fundamentals if you wait long enough. Next, we make sure we have enough capital behind our highest conviction ideas. It just so happens that due to the depth of the Chinese capital markets and the size of the economy, many of the best opportunities in emerging markets are domiciled there. This is not too different from the role the United States plays in global benchmarks.
Q: What about sector diversification, given the heavy weighting of tech stocks, and particularly Chinese tech stocks, in the benchmark?
CW: China has a number of truly unique, world-class companies that, depending on valuations relative to our expectations for long-term earnings power, may be multi-year portfolio holdings, though their weightings will vary over time. In our portfolio construction we diversify not just across sectors, geographies and market caps, but also across styles through our basket structure. It groups three types of stocks: basic value, in which companies generally exhibit more earnings volatility; consistent earners, which exhibit far less earnings volatility and more visibility; and emerging franchises, which are carving out new markets or displacing incumbents as they are either growing faster or have the potential to grow at above-average rates. The baskets really help us maintain awareness of relative value changes in turbulent times and across market cycles. That’s why we may be overweight or underweight certain sectors or countries at any given time, but we won’t be offsides on our basket parameters. We’re quite disciplined about basket balance because the discipline is both defensive and offensive, signaling when it’s time to reallocate after a good run in one area or another to segments that have greater upside potential.
Emerging Markets Value and Growth Stocks
Q: How does that signaling work in practice?
CW: In emerging markets value- or growth-classified stocks often become correlated across countries and sectors. That’s why we see “style risk” as a particularly important source of benchmark-relative risk. Consistent allocations to our three baskets help mitigate this type of volatility. But we also welcome the opportunities that come along when correlations spike and strong companies become mispriced across regions and sectors.
Value Vs Growth Performance
Performance % as at Oct. 28, 2020
Source: Bloomberg
Q: You run a concentrated portfolio of 40-60 holdings, a far cry from the 1,387 index constituents. The strategy is slightly underweight China relative to the index, but also has a mid-single digit allocation to Hong Kong, whose listed stocks aren’t included in the EM index. Can you talk about the portfolio’s volatility relative to that of the index?
CW: The challenge of fewer holdings is that we often deviate meaningfully from sector and country weights, which in theory can lead to higher benchmark-relative volatility. But because value or growth stocks can become correlated across countries and sectors, style risk is a really important source of benchmark-relative risk. That’s why our primary focus in constructing a concentrated portfolio is to balance value and growth investment styles relative to the emerging market universe.
Managing Emerging Market Currency Volatility
Q: The Chinese renminbi has appreciated around 4% against the dollar so far this year, though other emerging market currencies such as the Mexican peso and the especially the Brazilian real have lost significant ground against the greenback. How do you manage foreign exchange volatility and particularly the risk of sharp local unit depreciation for your dollar-based investors?
CW: We have the capability to directly hedge currency exposure to mitigate currency-related volatility. However, the currencies with the least attractive currency fundamentals typically cost the most to hedge, making the net impact of the hedges less effective in reducing the performance drag from a weakening currency. We generally find it more impactful to incorporate currency-related considerations into our bottom-up research process to estimate the potential impact of currency volatility on expected investment returns. This method also creates a consistent framework for comparing opportunities across markets with different economic fundamentals.
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