Why EM stocks are a better diversifier than some may think
Author: Regina Chi
September 13, 2018
Emerging market stocks haven’t always provided the necessary diversification that Canadian investors seek when choosing to invest overseas, but that may no longer be the case given the significant change in sector composition across the developing world over the past 10 years.
Historically, both EM and Canadian equity markets have been heavily weighted towards commodities with energy and materials companies making up close to 30% of the MSCI Emerging Markets Index and greater than 50% of the MSCI Canada Index in 2008. As a result, correlations between the two indices have been traditionally high, often leading to performance far less differentiated than desired in a well-balanced portfolio.
This relationship looks a lot different today, however. In large part, that’s because of the technological transformation underway in emerging markets that has pushed companies like Tencent Holdings Ltd., Alibaba Group Holding Ltd. and Samsung Electronics Co. Ltd. onto the global centre stage. By turn, the information technology sector now boasts the biggest weighting on the MSCI Emerging Markets Index, increasing to 27% from 10% a decade ago. This compares to the weighting of energy and materials companies that have fallen to 15% over the same period.
In Canada, meanwhile, major equity indices are still dominated by financials, energy and materials (albeit less so by the latter two) and this shift in relative sector composition has helped lower the correlation with emerging markets to a level that provides better diversification to those with exposure to both markets.
Beyond this particular advantage, Canadian investors who have some percentage of emerging market equities in their portfolios may also benefit from an asset mix that is more closely aligned with the global universe for stocks.
This is particularly true of those with a strong home bias. On average, Canadians allocate roughly 54% of their holdings to domestic stocks, according to data compiled by the International Monetary Fund. And yet, Canadian equities only represent about 3% of the global equity market (as represented by the MSCI All Country World Index). Moreover, while Canadian investors allocate the rest of their portfolios globally, it is likely that allocations to EM stocks fall well short of their 12% total representation of the global market in many cases.
Ultimately, we believe emerging markets equities represent a long-term secular growth opportunity fueled by a rising middle class that is dominated by emerging Asian countries and a positive GDP differential vs. developed markets. And with EM equities currently trading at considerable double digit discounts to Canadian and U.S. equities, now may be an attractive time to buy in.
The commentaries contained herein are provided as a general source of information based on information available as of Sept 10, 2018 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. We strongly recommend you consult with a financial advisor prior to making any investment decisions.
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