Covered: Is your emerging market portfolio as diversified as you think?

Fears over concentration in equity markets are hardly a new development, but the concern has become particularly acute in emerging markets this year.

In absolute terms, it has been a fantastic year for emerging market investors, with the MSCI Emerging Market index up 20.6% year to date. At one point, it had rallied as much as 31% in sterling terms, before a correction at the end of July. For comparison, the wider MSCI ACWI is up just 12.4% year to date.

However, as investors are now increasingly aware, this strong performance is obscuring an extremely narrow thematic trade.

Much of this performance has been driven by a handful of technology and memory-related names: TSMC, Samsung Electronics and SK Hynix. These three stocks alone represent more than 25% of the MSCI EM index’s allocation at the time of writing.

See also: Memories of tech bubble rise as AI stocks sell off

Broaden this out further, and market concentration in EM becomes even more concerning.

The top 10 stocks in the market represent roughly 40% of the total allocation, and seven of them – TSMC, Samsung Electronics (including preferential shares), SK Hynix, MediaTek, Delta Electronics, and Hon Hai Precision – are related to AI and technology in some way.

Stefan Sommerville, investment specialist at Orbis, noted that as a result, a passive investor buying into EM markets today is making a “concentrated wager on the AI investment cycle, dressed up as a diversified allocation to the developing world”.

Zoe Kan, manager of the BNY Asian Income fund, noted tech concentration may be even higher than the headline 40% figure suggests.

“In reality, AI-related beneficiaries such as utilities and industrials drive concentration risks around AI higher,” she said.

However, it is not just passive portfolios that perpetuate this concentration problem; active managers do it too, according to Vera German and Juan Torres, managers on the Neuberger Emerging Markets team.

They pointed to data from Copley Fund Research earlier this year which found some 93% of active emerging market fund managers currently own TSMC in some capacity. A further 85% own Samsung Electronics, 74% own SK Hynix and 63% own MediaTek; this same research found.

“Where’s the diversification on any of these managers, regardless of their strategy, of their timeframe, of how they define a good company,” Torres said. “What’s the point? You might as well buy an ETF if it’s cheaper.”

In this sense, German and Torres argued, many managers are not as different from the benchmark as they claim. Even global managers were guilty of this, with Copley Fund Research data finding that around 66% of active global funds have an allocation in TSMC.

“Every investor is very concerned about the shrinking markets, but I really don’t understand why when everyone owns the same 10 stocks as everyone else,” Torres told Portfolio Adviser.

‘The market extrapolates into the future’

These heightened levels of concentration present clear risks for investors, with BNY Investments’ Kan noting the challenges to volatility, performance and liquidity.

“Many managers are capped out at 10% maximum position size in TSMC, compared to its benchmark weight of over 15%,” Kan said. This makes it difficult for many funds to match the benchmark, with just 78 funds in the 179-strong IA Global Emerging Market sector beating the index year to date, according to data from FE fundinfo (roughly 43.6%).

Neuberger’s Torres also criticised the optimistic expectations priced into some of these names.

“The market extrapolates into the future; If a company makes 20 and it was expected to make 10, the market will extrapolate that and claim it will make 50 or 80; that’s exactly what it’s doing with TSMC,” Torres said.

See also: Neuberger Berman hires ex-Schroders EM value duo.

The question all investors must ask themselves then is if they believe these companies have made a genuine structural shift, or if this is just another cyclical business having a good run, he said.

His co-manager German added: “These valuations just rely on the idea that this goes on forever, and we just don’t think it will.”

Dirk Schlueter, head of CROCI investment strategies at DWS Asset Management, added that in some ways, the share prices of large EM tech companies had increased “far too quickly”.

“The large Korean memory chip manufacturers are currently on course to generate economic earnings roughly five times those of their previous all-time high,” he noted. “With their share prices having increased by a similar magnitude in the first half of this year, the market was effectively pricing these companies to be permanently much more profitable.”

This was a huge assumption to make about any set of stocks, let alone ones that experienced such heavy speculation this year, as demonstrated by the wave of leveraged single-stock ETFs in Korea, he noted.

“So, while it is entirely plausible that these companies will continue to make enormous profits for the next couple of years, markets may have got ahead of themselves, forgetting about these companies’ cyclical elements,” Schlueter said.

Neuberger’s Torres concluded: “It doesn’t really matter how good a company is; at the end of the day, you are operating in a geography or market environment that is not developed and will carry a lot of risks,” he continued.

“The fact that you’re putting investors’ capital in TSMC plus two other companies, which are cyclical in nature, in markets like Korea, feels like a risky proposition to us.”

Why it’s hard to see ‘cracks in the cycle’

However, for investors such as John Citron, manager of the JPMorgan Global Growth and Income trust, tech stocks in EM still have plenty of legs.

“The reason stocks have been so strong is that supply has been so constrained, because we came out of a Covid downturn and because we have a very fast iteration on the design cycle size.

“Companies like Nvidia are redesigning their products at such a pace that it’s hard for supply to get to an “oversupply” level.”

Coupled with the fact that names such as TSMC, SK Hynix and Samsung Electronics have been around in the EM tech sector since 2010, means these names may well be foundational and difficult to justify cutting despite the concerns about concentration, he said.

“Fundamentally, it’s very hard to see cracks in the cycle at the moment,” according to the JP Morgan manager.

Orbis’ Sommerville added TSMC is the largest holding in the Orbis Emerging Markets Strategy and Samsung Electronics remains a top five allocation.

“Both are central to the global semiconductor industry and are exceptionally well positioned within their respective segments,” he said. “We are comfortable with that exposure at the valuations we paid.”

See also: Allianz’s Seidenberg: Is AI market hype or the next great technology cycle?

‘The hand that passive investors are dealt’

However, he also noted this was an environment where active funds could really prove their worth through more well-balanced exposures.

DWS’s Schlueter agreed: “In general, with index concentrations so high, the case for active investment becomes stronger.

“We think it is essential to hold a well-balanced allocation [even in a thematic quality/growth strategy].”

In the team’s CROCI Innovation Leaders strategy, there is around 10% in Asian semiconductor names, but it is balanced by exposure to areas such as healthcare, which he saw as “the mirror image of technology from a market-perception perspective”.

Valuations remain relatively conservative and imply companies will struggle to replace much of their product pipeline, which he said “echoes the late 2000’s and early 2010’s”, when healthcare stocks were a compelling opportunity.

Orbis’ Sommerville noted that within their own portfolios, they hold everything from Brazilian digital banks to Chinese gaming companies and Indonesian infrastructure companies, all of which need very different things to go right.

“That, to us, is genuine diversification,” the Orbis specialist said. “Not simply a large number of stocks spread across multiple countries, but a collection of businesses whose long-term outcomes are driven by fundamentally different factors.”

“Emerging markets indices increasingly have a concentration problem. For passive investors, that is simply the hand they are dealt,” he said. “For us, it is a reminder of why we invest the way we do—selecting businesses one at a time, on their own merits, without regard for what the index tells us to own.”

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