Beware the hidden concentration risks in EM ETFs, says RAM AI

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Global economies and markets have been supported in the last nine years by a succession of liquidity injections by global central banks, increasing overall access to financing and lowering investors’ risk-aversion. As central banks, of which the Federal Reserve is the foremost, manage the exit of their monetary stimulus, investors should be wary of the associated risks.

After a remarkable recovery in the last two years, emerging markets, although still home to the primary growth drivers of the global economy, are once again exposed to large downside risks. For this reason, we believe sound risk management and a strong quality bias should be paramount when investing in EM today.

Perhaps the largest risk for those with an exposure to Emerging Markets is the concentration risk which we see in the market today. This is illustrated by our analysis of the current risk within market-cap based benchmarks. A large concentration of flows into ETFs have led EM investors to be disproportionately exposed to mega cap and large cap stocks, causing heightened concentration risks in these segments of the market.

Now more than ever we believe that investors could consider diversifying away some of this risk by active, more diversified and fundamentally-driven exposures into Emerging Markets. After analysing the current concentration of risk within a large market-cap weighted index like the MSCI Emerging Markets, the currently favoured benchmark for EM allocations, we stress the merit of diversification to avoid the downside risks associated with highly concentrated portfolio.

With nearly 60% of the MSCI Emerging Markets (EM) Index allocated to three countries (China, South Korea and Taiwan) and over 52% to two cyclical sectors in (IT and Financials), those investors relying on the index to gain exposure to Emerging Markets may find that they have also gained an unwanted exposure to the inherent concentration risks ingrained in such a concentrated weighting.

We’ve charted below the current vs average 10-year weighting of the top 50 stocks in the MSCI EM Index. This current level of concentration relative to the historical deviations, displays further evidence of the level of concentration facing investors.

The chart below highlights the high concentration of performance in the market-cap weighted MSCI EM Index from end of 2016 until last week. Since then the median name in the index was up 21%, the average of the index members’ performances was 29%, while the index progressed by 39.5% given the large concentration of the tail of performance in the benchmark within the index mega-cap heavyweights, as can be seen below.

What this means is that the MSCI Emerging Markets Index is particularly susceptible to any downturn in the performance of it’s strongest performers and which contribute so much to the overall performance of the index.

Investors often believe that an allocation to ETFs is a great way to reduce stock specific risk given their broad universe and large diversification in term of sector and country allocation. However given the trend in recent years, we feel that it might be time to be aware of the other risks that may come with ETF allocations, especially within EM.

Emmanuel Hauptmann is a partner and senior systematic equity fund manager at RAM Active Investments.

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