Ty Bernicke, CFP®, is President and Executive Wealth Manager at Bernicke Wealth Management based in Eau Claire, WI.
Over the 24 years that I have been in the investment business, there have been periods of excitement surrounding emerging market stocks. Emerging market stocks are domiciled in countries with fast-growing economies that are entering into the global scene. Investors frequently view these faster-growing countries as ideal investment opportunities without fully understanding the extent of their investment. Before investing in emerging market stocks, it may be beneficial to understand one of the potential pitfalls associated with this type of investing: concentration risk.
Concentration risk can occur when a mutual fund or an ETF has a disproportionately large percentage of the fund invested into one country’s stock market. If this heavily weighted country does not perform well, you may lose more money than a fund with a more consistent distribution among various emerging market countries. Unfortunately, concentration risk is especially relevant for several popular emerging market mutual funds and ETFs due to how these funds are constructed.
Several of the most popular emerging market funds tend to be capitalization-weighted index funds. These types of emerging market funds are frequently found as an investment option within 401(k) and other retirement plans. They also have become commonly used by investment advisors and do-it-yourself investors.
One of the disadvantages of capitalization-weighted index funds is related to their complete disregard for concentration risk. This occurs because the fund is required to place a higher percentage of the portfolio’s assets into the largest stocks within each country based on the stock’s market capitalization. For example, if one company is 100 times larger than another, it will receive 100 times as much weight. Additionally, if one country has more large companies, that country will get a heavier weight than a country with fewer large companies.
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Presently the country that carries the greatest weight in capitalization-weighted emerging market index funds is China. In several of these funds, Chinese stocks represent over a third of the total investment. This could amplify the risk for investors in emerging market funds as their investment becomes highly dependent on the success of China’s stock market. This concentration risk could be worrisome to investors for several reasons.
First, China is a communist country with a history of providing opaque and/or misleading information to foreign investors on various topics. China’s government also has a history of changing rules and regulations with little or no notice, which could unexpectedly impact companies in China’s stock market. These issues create an added element of danger to investing in China, especially considering how blurred the lines are between corporate and state ownership in Chinese-domiciled companies. Investing in stocks of communist countries carries an added layer of risk compared to investing in stocks of capitalist countries.
Another concern surrounding investing in China’s stock market is China’s total debt as a country. Presently it is estimated that China’s total debt is more than 300% of its gross domestic product. This figure has more than doubled since 2008. Its important to understand that total debt includes the government’s debt and the debt of China’s citizens and businesses.
This is important because, in a communist society, the definition of ownership can be obscured between what the government owns and doesn’t own. This would imply the government can be liable for debt carried by failing businesses regardless of that business’s ownership structure. And when much of the growth experienced by China over the past decade has been fueled by debt, there becomes a point in which the debt burden can become too large for economic growth, leaving only two options: issue less debt and grow slower, or continue issuing debt and risk undermining the country’s economic stability. Neither option is particularly good.
A final reason to examine investing in China can be attributed to China’s poor performance relative to other emerging market country stock markets. Currently, the MSCI Emerging Markets Index has over 75% of its total holdings invested in five countries: China, Taiwan, South Korea, India and Brazil. When looking at the return data for each of these countries going back over 26 years to 1995, we can see how the relative underperformance of Chinese stocks stacks up to its peers. The return on investment holdings focused on China is 146.37% while Taiwan (347.89%), South Korea (374.25%), Brazil (519.95%) and India (791.26%) all push well north of 300%.
As a reference point, the S&P 500 experienced a cumulative total return of 1,550% over the same period. The underperformance of China’s stock market relative to its peers does not necessarily mean that history will repeat itself in the future. Still, it does illustrate how returns can vary so significantly from one country to another over time. This should also provide context to the dangers of putting a large amount of money into any one emerging market country regardless of what country you choose to allocate toward.
The info I shared is based on my experience and provides a point of reference for investors rather than specific recommendations. While you can look at the historical performance of investments, you cannot see future results and investors should consider that all indices are unmanaged — and may not be invested into directly.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a registered investment advisor. Great Valley Advisor Group and Bernicke Wealth Management are separate entities from LPL Financial.