Seafarer addresses key questions about emerging markets investing and how U.S. investors can integrate the asset class into long-term portfolios.
What role can emerging markets play in U.S. investors’ asset allocations?
The emerging markets asset class can serve two useful roles in a long-term investor’s portfolio:
- Emerging markets offer a prospective source of diversified growth within a long-term investor’s portfolio. During much of the last 15 years, the concept of decoupling was in vogue for the emerging market asset class, but was overstated and misapplied. However, Seafarer believes that two recent structural changes – reduced reliance on exports and independent monetary policy – might finally allow the markets to decouple from the developed world. Decoupling is now relevant, for the first time.
- A high-quality, income-producing portfolio of emerging market securities (dividend-paying stocks and bonds) can act as a useful source of diversification (or hedge) against the U.S. dollar. Seafarer believes that long-term investors should seek exposure to productive assets with meaningful growth potential, and that are capable of generating income in currencies other than the U.S. dollar.
How should long-term investors integrate the emerging markets asset class into their portfolios?
The emerging markets are likely to remain volatile for the foreseeable future. Risk appetite must dominate any consideration of the asset class. Seafarer believes that investors should consider two key factors:
- Long-term time horizons are essential. Given the volatility of the asset class, due especially to heightened currency risk, Seafarer suggests that investors adopt a minimum investment horizon of five years.
- Investors should manage U.S. dollar versus non-U.S. dollar exposures in their portfolios. Rather than initially allocating capital among traditional “asset classes” (e.g., domestic stocks, foreign stocks, bonds, real estate), Seafarer believes investors should measure the portion of their assets that are principally denominated in U.S. dollars versus those assets that are not. After matching U.S. dollar assets against U.S. dollar liabilities, a portion of the surplus capital (e.g., 10% to 30%) can be allocated to the emerging markets.
How can U.S. investors understand and address the risks of investing in China?
China has rapidly emerged as a major investment destination for global investors. At the same time, political tensions between the U.S. and China remain high, with unpredictable consequences. Seafarer addresses these topics in several commentaries:
- In the white paper The China Investment Dilemma, Nicholas Borst examines how U.S. investors can navigate the dilemma of investing in China, a market that is too big to ignore but full of new and complicated risks. He offers a disciplined approach to evaluating how the challenges posed by the volatile U.S.-China relationship can impact investment returns.
- In an Asia Society Conference panel titled Rebalancing the U.S.-China Economic Relationship: Trade, Investment, and Technology, Nicholas Borst explains how the increase in holdings of Chinese securities by U.S. investors has emerged as a major source of conflict in the U.S.-China economic relationship.
- In a video discussion, Nicholas Borst, Paul Espinosa, and Andrew Foster explain that when evaluating emerging market companies, state control matters, more so than state ownership. Andrew outlines “exception” cases in which it can make sense to invest alongside a state control party, but explains that he wants to see state control decline over time, as more commercially oriented actors take greater control.
With high index exposure in a relative narrow set of companies, should investors in the emerging markets follow a passive market capitalization weighting?
At the heart of the emerging market (EM) asset class lies a conundrum. The asset class aims to track the financial markets of certain “developing nations” that have progressed beyond the initial stages of economic development (often referred to as frontier markets), but that do not yet enjoy the levels of industrialization, economic output or financial market sophistication achieved by wealthier nations (often referred to as developed nations). Thus, the emerging markets are bound by a nebulous standard: not over-developed, but developed enough to be deemed investable for certain purposes.
In A Tale of Two Indices Steph Gan discusses how EM index providers’ pursuit of scalability and replicability has taken precedence over fidelity to the fundamentals of the underlying markets. Steph uses an alternative, “positive” approach of measuring the EM equity universe to illustrate how leading indices’ subjective inclusion criteria has resulted in active tilts away from large swaths of the emerging markets. As shown in the table below, a comparison of constituent weightings reveals that in aggregate, the top 10 constituents in the MSCI EM Index (the “normative” index) receive a 50% higher weighting than in an objective, “positive” EM benchmark constructed to maximize representation.
|Constituents||Normative MSCI EM Index||Positive EM Benchmark||Normative MSCI EM Index*||Positive EM Benchmark||MSCI/Positive Weight Ratio|
|Alibaba Group Holding||1||2||5.77%||2.05%||2.8x|
|China Construction Bank||5||9||1.34%||0.78%||1.7x|
|Ping An Insurance||7||8||1.19%||0.80%||1.5x|
|Housing Development Finance||9||41||0.89%||0.21%||4.2x|
|Cumulative Weight of:||Normative MSCI EM Index||Positive EM Benchmark||MSCI/Positive Cumulative Weight Ratio|
|Top 10 Constituents||25.2%||17.1%||1.48x|
|Top 25 Constituents||35.2%||23.8%||1.48x|
|Top 100 Constituents||54.6%||37.3%||1.46x|
- *Where applicable, weighting aggregates across multiple listings for the same issuer.
- Sources: MSCI, Bloomberg, Seafarer.
- Seafarer defines an objective “positive” benchmark as comprising companies with an equity market capitalization of at least USD 100 million in 26 EM countries, as defined by MSCI: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
- As of December 31, 2020, Taiwan Semiconductor Manufacturing Co., Ltd. (TSMC) comprised 1.9% of the Seafarer Overseas Growth and Income Fund, Samsung Electronics Co., Ltd comprised 5.8% of the Fund, and Ping An Insurance Group Co. of China, Ltd. comprised 3.6% of the Fund. View the Fund’s Top 10 Holdings. Holdings are subject to change. As of December 31, 2020, the Seafarer Funds did not own shares in the other entities referenced in this commentary.