Concentration Risk if Overweighting EM Equity

[Northern Flicker]

Generally, investing in the equity of individual EM countries would be considered risky. EM equity portfolios benefit from diversification across many countries. Currently, however, about 2/3 of the market cap of EM equity indices is in equities of just 3 markets-- China, India, and Taiwan. (The percentage will vary a little depending on whether an all-cap index is used and/or whether a FTSE index that does not classify S. Korea as EM is used).

This seems to be a high enough concentration for there to be significant added risk to an equity portfolio if overweighting EM. EM is about 10% of market cap of a total world index.

[WhiteMaxima]

Single country Equity is very risky. A basket of multiple EM equity will reduce performance. My suggest is to stay with total world market ETF. BH don’t speculate any sect of the market.

[tibbitts]

Currently, however, about 2/3 of the market cap of EM equity indices is in equities of just 3 markets-- China, India, and Taiwan.

If you ask China they'd probably say you're counting wrong and that's actually two markets, not three.

[Northern Flicker]

Single country Equity is very risky. A basket of multiple EM equity will reduce performance. My suggest is to stay with total world market ETF.

That depends on the single country. I don't think you can increase expected return of EM by focusing on a single country, though that may take uncompensated risk that could be diversified away by holding EM via an index.

[Xexanoth]

Generally, investing in the equity of individual EM countries would be considered risky. EM equity portfolios benefit from diversification across many countries. Currently, however, about 2/3 of the market cap of EM equity indices is in equities of just 3 markets-- China, India, and Taiwan. (The percentage will vary a little depending on whether an all-cap index is used and/or whether a FTSE index that does not classify S. Korea as EM is used).

This seems to be a high enough concentration for there to be significant added risk to an equity portfolio if overweighting EM. EM is about 10% of market cap of a total world index.

Generally, investing in the equity of an individual country might be considered risky. Global equity portfolios benefit from diversification across many countries. Currently, however, nearly 2/3 of the free-float market cap of global equity indices is in equities of just 1 market -- the US.

This seems to be a high enough concentration for there to be significant concentration risk in an equity portfolio following global free-float market cap weighting.

(This is mostly tongue-in-cheek, but perhaps food for thought. Please avoid using this as an excuse to start debating US vs ex-US in this thread.)

[Northern Flicker]

Currently, however, nearly 2/3 of the free-float market cap of global equity indices is in equities of just 1 market -- the US.

While I think a US investor diversifies some risk by adding ex-US equity to a US equity portfolio, the single country risk of US equities for a US investor is not comparable. An EM market portfolio diversified across many countries is significantly riskier than a US market portfolio.

[Xexanoth]

Currently, however, nearly 2/3 of the free-float market cap of global equity indices is in equities of just 1 market -- the US.

While I think a US investor diversifies some risk by adding ex-US equity to a US equity portfolio, the single country risk of US equities for a US investor is not comparable. An EM market portfolio diversified across many countries is significantly riskier than a US market portfolio.

Agreed, but there'd likely be a significant difference in position sizing / exposure & associated risk to the overall portfolio. An overweight to EM that doubles its free-float market cap weight under current weights would mean about 6% instead of about 3% of an equity portfolio is exposed to equities in China, and about 3.7% instead of about 1.8-1.9% in each of India & Taiwan. Whether you consider an extra 7% or so of equity portfolio exposure across these 3 emerging markets unacceptable concentration risk might be informed by a comparison to 61% exposure to US equities, or 7% exposure across the 2 largest companies.

Do you consider the extra exposure to China and/or Taiwan particularly risky as a US investor given geopolitical tensions? Are you considering overweighting EM or already doing so, and seeking advice on how to mitigate risk? Or was this intended as a public service announcement for others considering or already overweighting EM?

[nisiprius]

Checking quickly...

... in VEUSX, the Vanguard European Stock Index Fund, the top three countries account for 56% of the fund... the top four, for 69%.

...in VPADX, the Vanguard Pacific Stock Index Fund, the top two countries account for 77% of the fund.

In other words, "concentration" in the Emerging Markets category is not unusual. It's much less than in Pacific stocks. And as Xexanoth has pointed out, it's less than that for the whole world.

You might just be talking about the natural structure of asset classes, not anything specially troubling about emerging markets.

Of course, overweighting emerging markets is risky in the first place.

[Northern Flicker]

And if you overweight the Pacific or European indices, you may be taking too much individual country concentration risk.

But EM is a separate case in my view because individual EM country equity is ultra high risk. EM as an asset class works because of diversification across countries, which diversifies some of the risk.

I don't see an issue holding EM at market weight or below. We hold VXUS at 25% of equities so EM is about 6.25% of equities, which does not concern me in this regard.

I think market concentration in EM currently is at its greatest level since the 1990s.

[nisiprius]

And if you overweight the Pacific or European indices, you may be taking too much individual country concentration risk.

But EM is a separate case in my view because individual EM country equity is ultra high risk. EM as an asset class works because of diversification across countries, which diversifies some of the risk.

I don't see an issue holding EM at market weight or below. We hold VXUS at 25% of equities so EM is about 6.25% of equities, which does not concern me in this regard.

I think market concentration in EM currently is at its greatest level since the 1990s.

It's very hard to measure the kinds of risk in emerging markets represented by (my underlining)

...

• Emerging markets risk, which is the chance that the stocks of companies located in emerging markets will be substantially more volatile, and substantially less liquid, than the stocks of companies located in more developed foreign markets because, among other factors, emerging markets can have greater custodial and operational risks; less developed legal, tax, regulatory, financial reporting, accounting, and record keeping systems; and greater political, social, and economic instability than developed markets.
• Country/regional risk, which is the chance that world events—such as political upheaval, financial troubles, or natural disasters—will adversely affect the value of securities issued by companies in foreign countries or regions. Because the Fund may invest a large portion of its assets in securities of companies located in any one country or region, the Fund’s performance may be hurt disproportionately by the poor performance of its investments in that area.

I don't think that language has changed. Vanguard specifically notes that the fund "may invest a large portions of its assets... in one country.

So acknowledging that we can't measure the real risks, if we just look at the "easy" risk measures, standard deviation and maximum drawdown, and use Vanguard's investor class US, Pacific, and Emerging Markets stock funds, we see as expected that EM is riskier than Pacific, and Pacific is riskier than US. Nothing new there. Anyone who chooses to overweight EM has accepted that additional risk. (EM advocates often downplay the risk, sometimes by dismissing it as home bias, but more often by asserting that the risk is rewarded).

Source



So emerging markets are riskier, the prospectus mentions country concentration... and the people who choose to overweight EM know it and believe it is compensated by the reward.

The question is: has it gotten much worse recently? Are there people who overweight EM who would change their minds if they noticed the increasing concentration?

You didn't mention a time frame when the concentration appeared, but let's split the available 29 years of data into roughly 5 years of recent data and the 25 years before that. Let's put the dividing point on a calendar year... 2019.

(Jun 1994 - Jan 2019)


(Jan 2019 - Aug 2023)


So measured both by standard deviation and maximum drawdown, emerging markets used to be riskier than it has been in recent years.

Just poking around thinking up arbitrary dates, again not knowing when EM became concentrated, if I worry about 2008-2009 warping the old data, and thinking maybe concentration is more recent, let me pull three boundaries out of a hat. If I throw out 2008-2009 for no good reason, and compare 1994-2007, 2009-2021, and 2022-present, I get:

(Jun 1994 - Dec 2007)


(Dec 2009 - Dec 2021)


(Jan 2021 - Aug 2023)


So there are many factors contributing to the risk of emerging markets, and if "increasing concentration in the top three countries" is one of them, it looks to me as if it is lost in the noise of all the other things... and there is no obvious hit-you-in-the-eye evidence that emerging markets have become even riskier than they always have been.

Emerging markets are risky. Overweighting them is risky. If you are right about "concentration risk" it's just one more thing on a long list, and it doesn't look to me like it is overwhelming compared to all the others.

[bendix]

What makes you want to overweight EM anyways? Do you have any insight knowledge that someone in the Chinese government has shared with you and we all dont know about? (sorry for trolling :>)

[SimpleGift]

When we invest in international stocks, whether in Europe or the Pacific or globally, we have the expectation that we are investing in capitalist enterprises operating in relatively free and open market systems. However, this is no longer the case in China, at least since the government "reforms" and crackdowns on corporate enterprise since November 2020:

A major effect of the crackdown has been a fundamental change in corporate governance. Platform tech companies have been forced into appointing state-nominated directors and issuing ‘golden shares’ in subsidiary companies to state-owned enterprises under joint venture partnerships. Such golden shares amount typically to only about 1 per cent of a subsidiary’s equity. But they bestow disproportionate corporate governance rights upon the minority shareholders. The state has acquired veto power over strategic decisions in those companies.

So the increasing risk of single country concentration in emerging markets since about 2020 is not related to normal market forces, but rather increasing government control and takeover of corporate enterprise. As a result, we have since sold our dedicated emerging market allocation that we’d held for many years.

[Northern Flicker]

What makes you want to overweight EM anyways?

I don't but many people do.

[Nathan Drake]

Generally, investing in the equity of individual EM countries would be considered risky. EM equity portfolios benefit from diversification across many countries. Currently, however, about 2/3 of the market cap of EM equity indices is in equities of just 3 markets-- China, India, and Taiwan. (The percentage will vary a little depending on whether an all-cap index is used and/or whether a FTSE index that does not classify S. Korea as EM is used).

This seems to be a high enough concentration for there to be significant added risk to an equity portfolio if overweighting EM. EM is about 10% of market cap of a total world index.

Are we really saying there's concentration risk in overweighting EM beyond it's typical 10-15% weight, despite only 66% being tied up into three countries comprising of thousands of companies, when many on this board have single country risk by being 100% US only, of which many of the very top names that comprise a VERY HIGH WEIGHT are highly dependent on single countries outside the US (like China)?

No, I would not be concerned about concentration risk in an EM markets fund and overweighting it a bit. I would be concerned about concentration risk for 100% US TSM only portfolios.

[Northern Flicker]

So measured both by standard deviation and maximum drawdown, emerging markets used to be riskier than it has been in recent years.

I think most of the drop in volatility is from the inclusion of China A-shares, for which published market prices have lower correlation with prices for other EM equity.

[Northern Flicker]

Are we really saying there's concentration risk in overweighting EM beyond it's typical 10-15% weight, despite only 66% being tied up into three countries comprising of thousands of companies, when many on this board have single country risk by being 100% US only,

Despite the number of stocks and countries, an EM market index fund is significantly riskier than a US market index fund. (Risk rating of 5 stars on Vanguard for VWO vs 4 stars for VTI). That should not be a controversial position.

With EM, any concentration risk of markets amplifies the typical EM risks (geopolitical, currency, etc) relative to greater diversification across EM markets. That is the point of the thread, as opposed to starting yet another thread on whether ex-US diversification is needed for US investors.

[asif408]

Are we really saying there's concentration risk in overweighting EM beyond it's typical 10-15% weight, despite only 66% being tied up into three countries comprising of thousands of companies, when many on this board have single country risk by being 100% US only,

Despite the number of stocks and countries, an EM market index fund is significantly riskier than a US market index fund. (Risk rating of 5 stars on Vanguard for VWO vs 4 stars for VTI). That should not be a controversial position.

With EM, any concentration risk of markets amplifies the typical EM risks (geopolitical, currency, etc) relative to greater diversification across EM markets. That is the point of the thread, as opposed to starting yet another thread on whether ex-US diversification is needed for US investors.

What you are saying is true at the individual country level, but it's an exaggeration of how most people invest. For instance, a global world market cap portfolio has 3% in China. There is more in Apple (4%) and Microsoft (3.5%) individually than China. And most hold less.

Even if you overweight foreign and EM what you are saying only applies to a significant overconcentration, and is only applicable to one or two countries. For example, I have a 45% EM weight in my overall portfolio, and a 90% total foreign allocation, which is significant overconcentration in EM. With a portfolio like this, with a standard EM index fund, the biggest EM weights are approximately 18% in China and 7% in Taiwan. Every other individual country position is 6% or less.

So, personally, my only concern is the China number, and I recently modified my EM holdings to adjust the country concentration to reduce the risk of overconcentration in China. Now, my biggest EM holdings are 9% China, 8% Taiwan, and every other EM country is less than 6%.

[watchnerd]

Generally, investing in the equity of individual EM countries would be considered risky. EM equity portfolios benefit from diversification across many countries. Currently, however, about 2/3 of the market cap of EM equity indices is in equities of just 3 markets-- China, India, and Taiwan. (The percentage will vary a little depending on whether an all-cap index is used and/or whether a FTSE index that does not classify S. Korea as EM is used).

This seems to be a high enough concentration for there to be significant added risk to an equity portfolio if overweighting EM. EM is about 10% of market cap of a total world index.

If you think the risk is too highly concentrated, don't overweight EM.

Seems simple to me.

[Valuethinker]

Generally, investing in the equity of individual EM countries would be considered risky. EM equity portfolios benefit from diversification across many countries. Currently, however, about 2/3 of the market cap of EM equity indices is in equities of just 3 markets-- China, India, and Taiwan. (The percentage will vary a little depending on whether an all-cap index is used and/or whether a FTSE index that does not classify S. Korea as EM is used).

This seems to be a high enough concentration for there to be significant added risk to an equity portfolio if overweighting EM. EM is about 10% of market cap of a total world index.

Note more than 25% of Taiwan, was, the last time I checked, composed of one company.

TSMC. Taiwan Semiconductor.