Just five large stocks account for more than 27.6% of the entire MSCI Emerging Markets index, which means even some of the best active managers may be forced to own more of them than they would like.
This is the case for Ben Durrant, manager of the Baillie Gifford Emerging Markets Growth fund.
Despite Baillie Gifford’s commitment to doing something genuinely different from the market, the portfolio has a 66% active share, “frustratingly” low by the stable’s standards.
When comparing the top 10 of the fund against the MSCI Emerging Markets index, there are six shared positions between the portfolio and the benchmark (TSMC, Samsung Electronics, SK Hynix, Tencent, Alibaba and Reliance Industries).
“We very reluctantly hold these large index positions; we would much prefer to be underweight them,” Durrant said, speaking at a recent roundtable.
“Just yesterday [speaking on 22 April] I went through the portfolio and thought, surely there must be something in the index that we shouldn’t own,” he added.
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However, these stocks have performed so well and are such an essential part of the market that owning them was the “right decision”.
For example, TSMC now represents more than 13% of the index, but it has surged more than 150% in the past 12 months, according to Google Finance, more than doubling investors’ money.
On top of this, the index itself has performed extremely well, with the MSCI Emerging Markets index up 48.3% over the past year and 63.3% over the past three, driven partially by these large stocks (data as of 27 April).
“In the context of our portfolios, which, generally speaking, are a small proportion of underlying investors’ portfolios, I think getting exposure to companies such as TSMC and SK Hynix is very important,” the Baillie Gifford manager said.
“They have just been the right thing to have owned and as of this moment, to still own,” Durrant continued. “The consequence of that, frustratingly, is an apparently low active share.”
This positioning has worked well for the fund, according to data from FE fundinfo. As demonstrated by the table below, it has outperformed the average IA Global Emerging Markets sector peer as well as the index over the past one, three and 10 years, only faltering over the past five.
However, Durrant said many of these index positions are legacy holdings from when the Baillie Gifford team invested in these stocks early.
For example, the team has held the TSMC position for more than 20 years, since “it was just another upstart semiconductor business,” and investors did not recognise the competitive advantages.
“It’s not that we’ve moved towards the index; it’s just that the index positions we’ve already held have done well,” Durrant explained.
That said, while owning the index has been a “reluctant” compromise in EM, there was still room for the Baillie Gifford team to express their actively-managed approaches, for example, through their position in Vietnam.
“We just think it’s completely forgotten about because people classify it as a frontier market.”
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It is set to be upgraded to secondary emerging market status this year, but it is still a zero per cent weighting within the index, he explained.
However, “Vietnam is the next best global growth story out there, the next manufacturing success story akin to Japan, Korea and China,” he said.
There are businesses in Vietnam that serve China and the rest of the world, but that trade on “half, or a third of the multiples of an Indian business.”
He argued that it was one of the primary beneficiaries of the “China plus one” strategy. This refers to the business strategy where firms attempted to diversify their supply chains from China.
Within the market, they have found opportunities in IT and retail stocks, but the manager also noted that property looked attractive, while Chinese property was “in the doldrums” and India’s has been weakening, Durrant explained.
Nevertheless, he conceded that the team was currently a bit more cautious on Vietnam, due to potential short-term volatility.
“It’s an energy importer, so it will do relatively less well now than it would have done with lower energy prices.” Coupled with the market’s sensitivity to retail flows and investor sentiment, it can be quite challenging as a short-term investment, Durrant said.
However, this has not deterred the team. “We love Vietnam. Short term, it’s always going to be very volatile, but in 10 years, we think it’s going to be a fantastic economy,” Durrant concluded.
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