When it comes to emerging markets, small is beautiful

With concentration increasing in major emerging market indices, small cap companies can offer investors welcome diversification, says Will Ballard.

When it comes to emerging markets, small is beautiful

On November 3, 2020, the market woke up to the surprise announcement that the world’s largest initial public offering (IPO) had just been suspended by the Shanghai Stock Exchange. In China, decisions like that don’t happen without the support of the top levels of the political apparatus. As such, it was an ominous sign for the company whose $37 billion IPO had been thwarted, fintech firm Ant Group, and its affiliate, the online marketplace Alibaba, China’s answer to Amazon.

Investors were rattled. Alibaba’s share price fell almost 30 per cent over the following two months, wiping out $240 billion worth of value.1 Jack Ma, the billionaire founder and face of Alibaba and Ant, should have been highly visible in the media, offering reassurance to the market. But he had vanished, leaving only a rumour-fuelling vacuum. (After a three-month absence, he finally re-emerged on January 20, posting an online video in which he pledged to devote himself to “education and public welfare”.2)

So why is all this of such crucial importance to the average investor in emerging markets? After all, Alibaba is just one stock, and the MSCI Emerging Market Index covers nearly 1,400 companies. Most investors looking for general emerging market exposure have flocked to passive funds tracking this index. While active managers might focus on the prospects of a single country, sector or company, surely passive investors can rely on the index’s phenomenal variety to diversify away such risks? Unfortunately, this historic assumption is being thrown into question by an increasingly significant issue: index concentration.

Trustbusting in tech

The top five stocks in the MSCI Emerging Market Index now account for a quarter of its exposure (see Figure 1). Furthermore, all of them – Alibaba, Tencent, Meituan, Samsung Electronics and Taiwan Semiconductor (TSMC) – are either internet or technology companies. Considering Alibaba, Tencent and Meituan are all Chinese internet companies, the fate of Jack Ma, and what it tells us about the government’s current view of that sector, suddenly becomes a very real concern to even the most passive of investors.

The Chinese government is clearly concerned about the dominant position of these giants

Alibaba isn’t necessarily being singled out: others in the internet sector are feeling the power of Chinese regulators. Meituan, the online grocery and food delivery service, trades on an expected 392 times next year’s earnings – a multiple that appears to do little to discount the recent news that the company is facing an antitrust case over abuse of its supposed dominant market position.3 The case is linked to its removal of Alipay, a payment service owned by Ant Group, from its platform to the benefit of TenPay, Tencent’s equivalent (Tencent happens to be one of Meituan’s largest shareholders). The Chinese government is clearly concerned about the dominant position of these giants and their negative impact on smaller online players.

Figure 1: Top five stocks as a percentage of the MSCI Emerging Market Index
Top five stocks as a percentage of the MSCI Emerging Market Index
Source: Bloomberg data, as at November 30, 2020

Herd behaviour

While few would argue this regulatory attention will precipitate a sudden collapse in the wider Chinese tech sector, history teaches us periods of extreme market concentration do not tend to end well. Following major market corrections, the stocks with the highest weights have historically generated poor subsequent returns, providing little protection to investors as the market falls.

Following major market corrections, the stocks with the highest weights have historically generated poor returns

This was certainly true for emerging markets at the time of the global financial crisis in 2007-2008. When the crisis hit, the top five stocks were a mixture of commodity, telecoms and technology companies, making up 15 per cent of the index. Four of those companies underperformed the index for the next decade.

Concentration risk isn’t just an issue for emerging markets. In the US, investors are facing a similar problem; the market is dominated by Apple, Microsoft, Amazon, Google and now Tesla. Figure 2, below, shows the weighting of the top five stocks in the S&P 500 going back over 30 years. The exceptional levels of concentration seen during the dot.com bubble of 2000 are nothing compared to where we are now.

Figure 2: Top five stocks as a percentage of S&P 500
Top five stocks as a percentage of S&P 500
Source: Bloomberg data, as at November 30, 2020

Each time investors have herded into more and more concentrated investments the result has usually been the same: a significant equity market correction, a step-up in volatility, and a change in market leadership. For example, Cisco Systems, one of the mega-caps of the dot.com bubble, has under-performed the S&P 500 for the subsequent 20 years.

With the emerging markets index at its most concentrated in terms of companies, the problem is further exacerbated by the fact that investors are herding into particular industries and countries. So, what is the solution for international investors who still want exposure to the unique opportunities of emerging market equities? How can they best achieve genuine diversification in the asset class?

Volatility and diversification

Looking back at the past 20 years, it becomes clear that adding smaller emerging market companies to a balanced portfolio provides the diversification investors need. The past two decades have brought periods of turbulence across emerging markets: the bursting of the dot.com bubble, the financial crisis, the taper tantrum, the China ‘A’ share crash and the COVID-19 pandemic. Throughout these events, and despite the increased liquidity risk inherent in investing in smaller companies, their inclusion in portfolios has proved beneficial, providing diversification and a counterbalance to the problem of concentration risk.

Including smaller companies in portfolios has proved beneficial

There is also evidence that such a strategy improves investors’ risk-adjusted returns over the long term. If you had bought and held the MSCI Emerging Market Small Cap Index for any continuous five-year period over the past 20, you would have outperformed the large cap index more than 70 per cent of the time (see Figure 3).

Figure 3: Frequency distribution of five-year annualized rolling relative returns
Frequency distribution of five-year annualized rolling relative returns
Past performance is not a guide to the future. Source: Bloomberg data, as at 30 November 2020. The chart presents the frequency distribution of 5-year annualised relative returns, rolling monthly, of the MSCI Emerging Market Small Cap TR Gross Index versus the MSCI Emerging Market TR Gross Index for the past 20 years

There is a popular misconception smaller companies, despite their attractive potential returns, significantly increase investors’ risk. This is partly due to the experience of investors in developed markets. Volatility, which measures how much a stock or index moves over any given period, has historically been higher for small caps than for large caps in developed markets. A two percentage-points differential in volatility may not seem much to the casual observer, but at times when index volatility has been at historic lows, this represents a clear difference in risk.

However, in emerging markets – which have a different index structure and comprise a larger number and wider range of companies – this relationship is turned on its head. Over most historic periods, the emerging market small cap index has generated stronger returns despite lower volatility, or less abrupt price moves (see Figure 4).

Figure 4: Small cap–large cap rolling annualised realised volatility (per cent)
Small cap–large cap rolling annualised realised volatility
Past performance is not a guide to the future. Source: Bloomberg data, as at August 31, 2020. Emerging Markets are MSCI Emerging Market Small Cap Index realised volatility – MSCI Emerging Market Index volatility. Developed Markets are MSCI World Small Cap Index volatility – MSCI World Index volatility

Better historic returns, combined with diversification benefits and lower volatility, add up to a strong argument for investing in emerging market small caps. Including small caps in a portfolio composed predominantly of large cap emerging market stocks can bring a small increase in expected return – and more importantly, a substantial reduction in risk.

Figure 5: 20-year efficient frontier (MSCI EM Small Cap and MSCI EM Index) (per cent)
20-year efficient frontier (MSCI EM Small Cap and MSCI EM Index)
Past performance is not a guide to the future. Source: Bloomberg data, as at 30 November 2020. MSCI Emerging Market Small Cap TR Gross Index versus the MSCI Emerging Market TR Gross Index shown

Countries and sectors

The addition of small caps to a balanced emerging markets portfolio not only helps to ameliorate the problems that stem from the dominance of mega-caps in mainstream indices; it also addresses market concentration risk. China’s weighting in the large cap index is already over 40 per cent and is set to grow as domestic ‘A’ shares are more completely incorporated. By comparison, the structure of the MSCI EM Small Cap Index is such that its spread of country risk is much broader. Taiwan, the largest country in the MSCI EM Small Cap Index, weighs in at only 20 per cent.

There seems little chance that the inexorable redistribution of global supply chains away from China will reverse

This concentration of country risk matters when investors consider the current path of geopolitics. Despite the recent change in administration in the US, there seems little chance that the inexorable redistribution of global supply chains away from China will reverse. The changing shape of globalisation is not caused solely by the blunt force of trade tariffs that proved such a strong catalyst over the past couple of years. Labour cost advantages in Indonesia, Vietnam or India are another consideration, while the proximity of exporters in Mexico, Turkey or the Czech Republic to their destination markets matters. These structural factors all play into a trend that could last for the next decade. With significantly higher exposure to non-China export countries than large caps, small caps in emerging markets are set to benefit from these potential changes.

Figure 6: Relative country weights of MSCI EM Small Cap Index versus MSCI EM Index (per cent)
Relative country weights of MSCI EM Small Cap Index versus MSCI EM Index
Source: Aladdin data, as at November 30, 2020

The make-up of the MSCI EM Small Cap Index demonstrates similar offsetting benefits with respect to sector concentration. Unlike the concentration of state-owned enterprises that are often maligned by investors in the large cap index, the small cap index includes many domestically focused companies. These tend to provide greater exposure to specific sectors. The consumer, industrials, healthcare and real estate sectors currently make up nearly half of the index, compared with just over 30 per cent for the large cap index.

Active management can provide additional advantages, by allowing investors to select small cap stocks that look particularly well positioned to benefit from long-term structural change, along with those whose performance drivers complement the large cap names in a wider emerging market portfolio.

Figure 7: Relative sector weights of MSCI EM Small Cap Index versus MSCI EM Index (per cent)
Relative sector weights of MSCI EM Small Cap Index versus MSCI EM Index
Source: Aladdin data, as at November 30, 2020

Bubble trouble

From the Dutch tulip bubble in the 17th century to the South Sea bubble in the 18th, from the US railroad boom in the 19th century to the dot.com bubble and financial crisis of more recent memory, history has shown us time and again that the symptoms of speculative excess are not hard to spot. A concentration of investors in a small number of stocks is one such warning sign.

History cannot teach us how to pick the turning point

What history cannot teach us is how to pick the turning point. Individual macro or political events that trigger a change in investor appetite are hard to identify until after the fact, and the regulatory crackdown on technology firms in China and elsewhere is just one potential hazard.

However, investors can gain some protection by mitigating the danger around these hotspots. Smaller companies in emerging markets provide diversification away from these concentrated risks. At the same time, they continue to provide exposure to those changing structural trends that will reward the patient investor. Now may be the time to step away from the crowd and seek out these different opportunities.

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