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Monthly Market Muhsings - July 2021

Markus Muhs - Aug 04, 2021
Emerging Markets had a horrible month in July. Why, and do they still belong in your portfolio?
With North American large caps hitting new highs across the board, international developed markets turning in a positive month, and U.S. small caps and emerging markets both going the opposite direction, markets remain as unpredictable as ever. I say that not out of frustration (as someone who believes strongly in having a reasonable allocation to small caps, and who banged the drum on emerging markets last month), but simply to state a fact.
We can’t predict the markets… ever. Not for the day, nor the month, nor the year. Anyone who thinks they can is delusional. All we can do is take a reading of where we are currently and where opportunities might lie. Whether or not those opportunities materialize as gains in our portfolio over the next few months or year is entirely up to a roll of the dice.
Small cap stocks, for example, currently trade at historically low multiples relative to large caps. They’ve underperformed for a while now, even though the long-term history of small caps is one of outperforming large caps. Whether or not that trend reverts to the historical mean next month, year, or decade is impossible to predict. It’s simply our prerogative to invest in a diversified fashion; maybe allocating a bit more to unloved areas where there is more future potential.
Much the same can be said for emerging market stocks. Wow, did they have an epically horrendous month!
When you think about emerging markets, what comes to mind? Are you thinking some Latin American city with palm trees; perhaps a Brazilian favela? Eastern European cities recovering from decades of socialism? India? Are you thinking mostly mining stocks—the traditional big players in EM funds—and companies selling household goods to a booming middle class in the developing world?
Well, your perceptions of the emerging markets are somewhat right, but when you invest in EM these days your biggest allocation is actually to Chinese tech/communications/discretionary stocks.
Vanguard’s Emerging Markets ETF, which I use to track EM in the table above, represents a cap-weighted index of the countries defined as EM, and as you can see, as of June 30th China comprised over 40% of the fund. By the communist Chinese government’s definition of “China” you could even say it’s close to 60% (including Taiwan).
Top holding of pretty much every EM fund, whether passive or active, is Taiwan Semiconductor (thus the outsized allocation to Taiwan). This company has become huge over the past decade and you might not think your computer or device has their products in it, but TSMC does a lot of the actual fabrication for AMD, Apple, and Nvidia.
The next two companies, Tencent and Alibaba Group, between the two of them, can kind be thought of as the Chinese equivalents of Facebook, Amazon, Netflix, Electronic Arts, Square, Shopify, and Alphabet combined. More than just serving China and other EM countries, these companies sell a lot of their services in the developed world too. You might have blinked if you didn’t notice Tencent’s logo pop up at the beginning of some major films, and if you or your kids play League of Legends or Fortnite, you’re using a product of one of their fully or partially owned subsidiaries.
In short, EM may not be what you think it is. At least not when owning the index.
Whether it was their communist government’s intention or not, China had a really awful month of July. Looking at the Canadian-listed XCH (iShares China) to translate the return into Canadian dollars for us, Chinese large cap stocks were down nearly 12% for the month of July. Year-to-date, Chinese stocks are now down 14% and even their three-year compound annual return is negative.
I don’t aim to figure out exactly what the Chinese government did to cause these share prices to tumble, or why. Suffice it to say that it’s a risk that accompanies investing in communist countries.
What I do mean to suggest though, is that maybe emerging markets are a space where we want to be a little less passive in our portfolios.
This area of the world—more than half the population, a quarter of the global economy, but only a tiny portion of global market cap—can’t be avoided. Not only are the world’s younger and growing populations predominantly in those countries (with exception of China, which is expected to face a demographic crisis much like Japan’s in coming decades, but that’s a whole other thing), but it’s also where we see the most social and economic progress happening. These countries are urbanizing rapidly and hundreds of millions of people are being uplifted into a middle class that spends more money on stuff. The growth engine that America was 100+ years ago, the EM economies are now.
I like passive indexing for big, well-established, diverse and efficient asset classes, but I don’t like passive indexing for EM. To start with, what’s the definition of EM? It isn't simply all the countries that aren't developed. The EM index funds own the stocks from a list of countries that were arbitrarily defined as EM, and nothing more. There’s a whole other group of developing countries, called “Frontier Markets”, which an EM index mandate can’t touch, but an active fund can. Why are Brazil, Colombia, and Chile included in EM index mandates, while Argentina, Ecuador, and Paraguay are not? It’s their economic status, I know, but why would you not want to just invest in all of ‘em?
Why not also invest in developed market companies that do a lot of business in the developing world? Especially consumer goods companies. And what is South Korea classified as anyway? It varies from source to source, whether they’re developed or emerging, but the FTSE Russell index that Vanguard uses for the fund above excludes them.
Beyond that, there’s always the hope—but no guarantee—that competent active managers can avoid or underweight problem areas of the world instead of blindly owning all EM countries as determined in proportion to the size of the companies within them.
An active EM fund that I use in my portfolios, which I won’t reveal here because I don’t want to make this an advertorial for the fund company (it’s the lowest-costing EM fund in Canada that is neither index-based nor has a high minimum purchase requirement, with an MER of just 1%), has the above allocations.
China still rules in the fund, as does TSMC, but you can see how an active approach can provide us a portfolio that is quite different; perhaps more like what we perceive an EM fund to be. It still had a terrible month—unavoidable when China is the largest allocation—but their active managers deliberately had only a half allocation to mainland China. 
You can see also, by way of allocations to South Korea and Hong Kong, the fund isn’t bound to any specific “rules” as to what constitutes an EM stock. The fund’s second-largest holding is SK Hynix, a South Korean manufacturer of ever-vital DRAM and flash memory chips. A Chilean copper miner also rounds out the top-ten holdings, tilting the fund a little closer toward what we expect from EM funds. That company, Antofagasta PLC, is entirely omitted from the EM index ETF because it is headquartered in the UK, even though its business is primarily in Chile.
Although I’m often trumpeting index investing, there’s room for active management in parts of your portfolio, and I think EM is one of those parts. Too often people get dogmatic about the whole passive/active investing thing and keep a closed mind to any and all active strategies, and I think that can be detrimental.
Closing off, I saw a really excellent tweet this month that I wanted to share here. It applies to all equity investment, but probably is more apt for EM investors of late. If a 5%+ pullback in EM stocks concerns you in the slightest, then stocks are not a place where you want to be investing in the first place. 
Markus Muhs CFP, CIM
Investment Advisor & Portfolio Manager
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