By Steven A. Schoenfeld, Founder and Chief Investment Officer, BlueStar Indexes.

Steven A. Schoenfeld, Founder and Chief Investment Officer, BlueStar Indexes.

A new ‘elephant’ in the room: The panda

Investors are on the cusp of the largest shift in the risk profile of emerging market benchmarks since these indexes were first launched more than 30 years ago.

At the end of May, the flagship MSCI Emerging Market Index will be significantly altering its country weights. Between the end of May and the end of November, MSCI will be quadrupling China A-Shares exposure and adding Saudi Arabian stocks.

This transformation of the benchmark that guides approximately $1.8 trillion in indexed and actively managed emerging market assets will have an enormous impact. Notably, FTSE Russell will also begin adding Chinese A-Shares to their emerging markets index in late June, with similar ramifications.

From June 1st, MSCI’s China A-Shares weighting will grow from 1.1% to 3.3% by the end of November; Saudi Arabia’s weight will likely double from 1.4% to 2.8% in August.

Therefore, by next month the concentration risk of the top five emerging markets will encompass more than two-thirds of the index. By the end of this year, the top 10 emerging markets will account for close to 90% of MSCI’s flagship EM index.

It is quite possible that by 2022, Chinese equities with full A-Share inclusion will be close to 45% of MSCI EM. If South Korea graduates to developed market status (as it has in similar FTSE Russell and S&P indexes), the total China weight could approach 50%.

This would constitute an unprecedented concentration of multimarket benchmark weight in a single country, and with the already high concentration in the top 10 markets, it would effectively render many of the smaller 15 countries that remain almost irrelevant.

Combined with the growing weight of Chinese equities, BlueStar strongly believes this ‘Panda in the Index,’ will lead investors of all types to consider alternative benchmark weighting approaches.

Controlling emerging market risk: Single-country and sector concentration

One way to address the growing concentration risks in the dominant emerging market benchmark is to construct alternatively weighted index strategies. BlueStar Indexes has a legacy of emerging market thought leadership stretching back to the early 1990s. During this time, we have observed the weight of single countries rise and fall as isolated crises devastated local markets.

Major single country drawdowns since mid-1990 include:

• Mexico in 1994/95, when Mexican equities had a 22% weight in MSCI EM – and subsequently suffered a ‘Tequila Crisis’ which saw the country index drop 66%
• During the 1997/98 financial crisis, Brazil, which then had a 21% weight, was down 53%
• In 2008, Russia dropped 76%, from a weight of around 12% to less than 4%
• And in 2015 – China, with a weight in the mid-teens, dropped 44% in less than six months.

We are not predicting a similarly sharp drop in Chinese equities, though it is a possibility given the disruptive trade war underway between China and the US. But even if the risk of such a correction may be low, having an index-tracking strategy with more than one-third of its weight in a single market can be considered imprudent.

Furthermore, single-country risk has historically been the main driver of EM portfolio risk, but as the world becomes more interconnected, sector concentration risk is increasingly becoming a driver of forward-looking risk as well. EM country and sector concentration is a natural outcome of cap-weighted index construction and should be assessed – and in our opinion, challenged.

BlueStar has designed several index-based solutions to mitigate the impact of idiosyncratic country and sector specific events, while considering other risks relevant to EM investors including operational risk, liquidity, stage of development, and volatility/correlation among countries and sectors.

The result is a strategy index that delivers broad emerging market exposure using a methodology that re-allocates the weight from highest-weighted countries to those countries that have relatively low correlation to them.

But regardless of one’s investment approach and vehicles, investors must be aware of the current concentration risks in emerging market benchmarks, and how they will grow even larger starting next month…Caveat Emptor.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)