The emerging market sometimes pops up where one least expects it. For example from those global equity funds that compare against the MSCI World index. This basket consists of 1.646 mid- and large-cap stocks from 23 countries. Even if this seems to be a reasonable representation of investment opportunities on a global level, one asset is missing, at least in appearance, which for better or for worse is crucial: developing countries, in fact. This can be a problem, especially when it comes to the risk appetite of an investor who may not like the uncertainties associated with markets other than developed ones.
While it is true that emerging markets are not part of the MSCI World Index, it is also true that global fund managers often have the flexibility to go fishing in those areas to gain direct exposure to their fast-growing economies: both for increase returns, rather than mere diversification objectives. This is more evident in managers who choose MSCI ACWI or FTSE World as their official benchmark. In fact, both have exposure to developing countries, albeit minimal.
Staying on the surface
“Although the leeway to invest in stocks outside developed markets is generally limited, global funds at the economy level have higher exposure to this asset greater than their direct investments indicate,” explains Jeffrey Schumacher, Associate Director of Morningstar's Manager Research. “We analyzed 112 open-ended, active and ETF funds that have a Morningstar Analyst Rating and that had portfolios updated as of March 31, 2017. At first glance, most of the funds in this sample invest directly in emerging areas, although often in marginal way. The average asset class allocation at the end of March 2017 was 3,3%. Then there are 21 funds which, again at first glance, have no direct exposure to emerging markets. Of this subset, only nine funds have had no direct exposure over the past three years. For most global equity funds investing directly in emerging markets, the allocation typically never grows above 5%. Only a handful of funds invest a significant portion of their assets in developing countries, with direct exposures exceeding 20%”. That, at least, is what it appears on the surface.
Looking deeper
In sum, an analysis of global equity funds' direct exposures to emerging markets indicates that exposure to the region is generally limited. “However, traditional methodologies that classify a stock as belonging to a certain country or region don't always give a complete picture,” Schumacher says.
Traditional classification methods often categorize companies based on where the stock is listed, where the company was founded or where its headquarters are located. However, this approach does not necessarily reveal a company's economic exposure to a particular country or region, which is more relevant from an investor's perspective.
In an increasingly globalized marketplace, businesses have become less dependent on their country of origin. A company's economic exposure to a country or region is therefore the result of several variables, including: where it generates revenues, the location of its manufacturing facilities, where its suppliers are located and the extent to which currency are hedged. As a result, a company's revenues and profits are often exposed to economic activity that takes place far beyond the company's home country.
The mining company BHP Billiton, for example, is listed in London, but is heavily dependent on the economic conditions of emerging countries and in particular of China. Its mining and oil operations, meanwhile, are in Australia, the United States and South America. As a result, it does not behave like a typical developed market stock, and cannot be a gauge for the UK economy. This stock is heavier in the MSCI Emerging Market Index than in the FTSE100.
To go beyond the geographic classification of stocks, investors should look to analyze fundamental data such as revenue or earnings splits to reveal a company's underlying regional exposure. However, there may be limitations in terms of data comparability, availability and quality.
Everyone has a bit of emerging
“Using Morningstar's Risk Model (an analysis of the risks hidden within an investment asset) to analyze the possible exposures of the examined funds to seven emerging regions led to different conclusions than the traditional classification methodology” , says Schumacher. “Our model says that all funds in the sample had, as of March 2017, exposure to emerging markets. In detail, the average exposure to developing countries was 8,9%: three times that resulting from the traditional methodology. For portfolios that have no exposure to developing countries with traditional classifications, the risk model shows an exposure of 4,7%. For 48 funds, more than two-fifths of the sample, exposure to emerging regions as measured by the risk model was more than 10%. In the case of 13 funds, the Risk Model gave a lower result than the classic methodology”.
The table below shows the differences found in emerging market exposure for the sample of global equity funds using traditional classifications and the Morningstar Global Risk Model.
From the site morningstar.it.
