Study: Emerging Markets Offer Diversification -- But Not Through Funds

In recent years, throngs of investors have piled into emerging market exchange-traded funds, with many seeking to diversify their portfolios by investing in a broad swath of emerging market companies. But, according to a new study, emerging market ETFs may actually have the reverse effect.

The study, performed by The Brandes Institute, found that many emerging market ETFs are far more concentrated than many investors realize. “The number of companies available for investment in emerging markets is greater than that in developed markets, reflecting vast opportunity,” the study states. “Yet, the indices (and ETFs tracking these indices) designed to reflect emerging markets tend to be heavily concentrated in just a handful of companies. … Many passive investments are, in fact, extremely concentrated owing to the disproportionate size of their largest holdings and blindly weighting by market capitalization.” (Click here for a PDF copy of the study.)

The push into passive emerging market funds has been great in recent years, Brandes says. Ten years ago, active emerging market strategies managed 10 times as much as passive strategies; today, the amounts are roughly equal. (In the rest of the world, active strategies manage twice as much money as passive strategies, Brandes found.)

An example of how concentrated emerging market funds and indices have become is the S&P Global Broad Market Index. According to Brandes, 47% of the fund’s Brazil assets come from the five large largest Brazil holdings. In China, the top five account for 42%. Many such funds also tend to be concentrated in particular industries, Brandes said. Looking at that index’s top five holdings for each of the BRIC nations (Brazil, China, Russia, and India), 90% of the market capitalizations come from two sectors: financials and energy stocks.

Brandes also provides some more in-depth analysis of emerging market fund concentration. One of its key conclusions: Investors looking for opportunity and diversification in emerging markets should consider active investment strategies, rather than passive ones. “As emerging markets is now the largest region of the equity markets by number of investable securities, it may create opportunities for investors willing and able to invest actively outside of the largest securities,” the study says. “For investors seeking greater potential in emerging markets and enhanced diversification benefits, active managers may offer a more attractive alternative.”

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