Broad Is The New Narrow: How Passive Investing Creates Concentrated Portfolios

Brandes Institute

Brandes Investment Partners

December 1, 2013

Brandes Institute Research Paper No. 2013-06

Abstract:

Passive investing, particularly in emerging markets, has become an increasingly popular means of quick, “diversified” exposure to a particular segment of the markets. Flows into passive emerging market products have been so strong that assets in exchange-traded funds (ETFs) designed to capture this region of the world now rank second behind ETFs tracking the S&P 500 Index. Yet it’s the presumption of diversification that can lead investors astray. The number of companies available for investment in emerging markets is greater than that in developed markets, reflecting vast opportunity. Yet, the indices (and ETFs tracking these indices) designed to reflect emerging markets tend to be heavily concentrated in just a handful of companies. For investors seeking greater potential in emerging markets and enhanced diversification benefits, active managers may offer an attractive alternative.

Broad Is The New Narrow: How Passive Investing Creates Concentrated Portfolios – Introduction

Passive investing, particularly in emerging markets, has become an increasingly popular means of quick, “diversified” exposure to a particular segment of the markets. Flows into passive emerging market products have been so strong that assets in exchange-traded funds (ETFs) designed to capture this region of the world now rank second behind ETFs tracking the S&P 500 Index. Yet it’s the presumption of diversification that can lead investors astray. Many passive investments are, in fact, extremely concentrated owing to the disproportionate size of their largest holdings and blindly weighting by market capitalization. As emerging markets are now the largest region of the equity markets by number of investable securities, they may create opportunities for investors willing and able to invest actively outside of the largest securities.

The popularity of emerging markets, and in particular emerging-market ETFs, has reached an all new level. Recent flows have pushed the ratio of collective assets invested in passive and ETF strategies to active strategies in emerging markets to parity. That is, there’s as much money invested passively as actively today in emerging markets. Just 10 years ago, active strategies managed 10 times as much. While other areas of the world have also seen a surge of passively invested money in recent years, actively managed products still manage twice as many assets as passive strategies do.

Passive Investing

Looking across the universe of 4,897 exchange-traded funds globally, 34 ETFs1 track a broad measure of emerging markets (the overwhelming majority track the MSCI Emerging Markets Index). Aggregate net assets under management in these funds totaled $114 billion as of June 30, 2013. Additionally, there is another $33 billion in BRIC (Brazil, Russia, India, China) ETFs or its individual country components and approximately $3.5 billion in ETFs tracking regional carve outs of emerging markets (Asia Pacific, Latin America and Europe).

Passive Investing

What are the possible ramifications of this surge in passive investment on investors and markets in these areas?

Concentration Risk

ETFs have not provided the level of diversification many investors expect. As the majority of ETFs invest pro rata on a market capitalization basis, it means that the majority of flows are used to purchase shares in the largest companies. Those purchases in turn push prices and capitalization higher and, coupled by relatively consistent flows the past few years, have turned this pattern into a compounding cycle.

We analyzed the largest companies in the S&P Global Broad Market Index across various countries and identified how much of a country’s total capitalization was represented by just the largest five companies. As shown in Exhibit 3, BRIC countries tend to be “top heavy.” The largest five companies in Russia account for 46% of that country’s total market cap; the top five in Brazil account for 44%.

Passive Investing

As profiled in Exhibit 3, the largest five companies in each respective BRIC country also provided little diversification across sectors, being heavily weighted in just two. Roughly 84% of the capitalization of those 20 companies was in financials (banks) and energy (predominantly oil & gas). Exposure to these largest companies alone would miss much of what emerging markets offer and this becomes particularly evident when the number of companies in each emerging market sector are tallied on an equally weighted basis. The full 2,579 companies in the S&P Emerging BMI (Broad Market Index) were more broadly distributed, with no sector accounting for more than 20% of the index’s constituents. This reveals that beneath the top layer of concentration, emerging markets encompass a fairly diversified set of companies across the globe. See Exhibit 4.

Passive Investing

Additionally, emerging markets is now the single largest opportunity set globally. There are over 3,000 stocks in emerging markets with a market capitalization greater than $500 million, more than any developed market region in the world. Exhibit 5 profiles how this leadership position has evolved historically and transformed over the past 15 years.

Passive Investing

Conclusion

The number of companies available for investment in emerging markets is greater than that in developed markets, reflecting vast opportunity. Yet, the indices (and ETFs tracking these indices) designed to reflect emerging markets tend to be heavily concentrated in just a handful of companies. For investors seeking greater potential in emerging markets and enhanced diversification benefits, active managers may offer an attractive alternative.

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