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Emerging markets: The fad diet?

By: Mat Lystra, Sr. Research Analyst

I will be the first to acknowledge that emerging markets have fallen on hard times: heightened volatility, currency depreciation vs. the U.S. dollar, and political unrest have all conspired to cast a pall over the asset class. 

Especially hard hit have been China, Russia and Brazil, which make up three-fourths of the historically high-flying “BRICs” group of markets, and 50.4% of the FTSE Emerging (markets) Index.[1]  The recent poor performance of emerging markets has led some to suggest that cap-weighted benchmarks and the products that track them have growth too heavy[2] in countries like China and should be avoided. 

Instead, many of the products offered by critics of cap-weighted benchmarks promise all of the attractive qualities of emerging markets while being able to avoid any unwanted side-effects. These claims remind me of those extreme weight loss advertisements promising results simply by taking a pill when a balanced diet and regular exercise have always been a prescription for good health.

Broad based cap-weighted indexes represent the naïve view of the market—or so critics would say—by including all investable countries and stocks. In doing so, the benchmark provides index users with a proportionate representation of countries and stocks as valued by the market at a point in time. 

What cap-weighted naysayers might fail to see is that this method of index construction can in fact benefit the user who is making allocation decisions or investing in a product that tracks the index. Why? Because by including countries like China and Russia even when they are out of favor, broad-based benchmarks can provide a “balanced diet” of diversification.

As an example, Figure 1 shows the last 12 months of performance (total returns USD) for the all-cap versions of the FTSE Brazil, Russia, India, and China indexes, as well as the FTSE Developed Index. To varying degrees, each emerging country behaves differently from every other and from developed markets. This is the essence of diversification. While Russian stocks were hit hard by geopolitical concerns and a massive currency devaluation to end-2014, Chinese stocks were setting all-time highs. More recently India has taken some of the edge off China’s negative performance and had the lowest volatility among the BRICs.

And for those who now consider cap-weighted indexes a little too heavy in their weightings of certain countries, I’d ask them to consider the growth in emerging markets in just the last ten years. From 2005 through 2014 the market cap of emerging markets grew from $4.6T to $15T, an annual growth rate of approximately 12.6%. But take out the BRIC countries and you would have had less than half as much growth.[3]

Look, I’m not sure which emerging markets will lead the way in the future – that’s why I don’t sell magic pills. But I know that diversification can work and that the FTSE Emerging Index captures the investable opportunity set of a diverse group of countries and stocks.  I also know that sticking to a balanced diet is often hard, which is perhaps why cap-weighted emerging markets benchmarks are useful tools now more than ever.
 

[1] FactSet as of September 30, 2014

[2]According to index weighting by market value

[3]World Federation of Exchanges as of November 30, 2015

[4] Includes all countries classified as Emerging markets by FTSE as of September 2015

 

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