Emerging Markets from the Lens of a Canadian Investor

In the past, Canadian investors have overlooked emerging markets (EM) largely due to the similarities between emerging market economies and the Canadian market as both were overweight to energy, commodities and financials. In terms of portfolio construction, Canadians were advised to avoid emerging markets because it would add risk and volatility while doing little for sector diversification. Canadian investors looked instead to U.S. equities for growth solutions, turning to companies in the S&P 500 or the NASDAQ, and most recently to mega-cap FAANGs and other new economy companies. As a Canadian, if you bought the S&P 500 Index 10 years ago, you earned a 16% annualized return. This is an 11% improvement on the Canadian market and a 4% improvement on the MSCI World Index during the same time, so the strategy worked well. (Source: Morning Star Direct. Based on the S&P 500 TR Index, the S&P/TSX Capped Composite TR Index and the MSCI World GR Index as of October 30, 2020. Returns in Canadian dollars.)

While U.S. equities remain an important component in a portfolio as we look forward, Canadian investors should consider expanding their investment universe to seek out future growth opportunities beyond the U.S. and should revisit emerging market equities as an important building block in a diversified global portfolio.

The Evolution of Emerging Markets

Emerging markets have evolved. They are no longer resource based. In the past, these economies were concentrated in energy and materials which made up one-third of the EM market (Source: Bloomberg, October 30, 2020. Based on the MSCI Emerging Markets Index.)

Today, the MSCI Emerging Markets Index is 12% energy and materials while consumer discretionary and information technology have grown to a combined 40% weight (sectors which are still underweight in the S&P/TSX Composite Index; source: BMO Global Asset Management, as of October 30, 2020.) Many of the companies in the index are some of the largest companies in the world. These “new economy” businesses include Taiwan Semiconductor who has a global monopoly in the semiconductor space, e-commerce giant Alibaba who has over 700 million users, and video game mega cap Tencent whose market cap is greater than Facebook’s.

 The regional composition of emerging markets has changed too. Once dominated by South Korea, the index is now over 40% Chinese equities, doubling in size over the last ten years, a reflection of China’s ascent to the world’s second largest economy. Taiwan and India have held their weights steady combining for around 20% of the index. Overall, the index has become more globally diversified with 26 countries from almost every continent. The GDPs of these countries are much greater than those of the developed world, another testament to the growth potential in these regions. Currently, much of the growth in EM is fuelled by China. China’s returns this year have been much stronger than those in the U.S. The one-year return of the MSCI China Index is 35.4%, vs the S&P 500 return of 9.7% (Source: Morning Star Direct. Based on the S&P 500 TR Index and the MSCI China Index as of October 30, 2020. Returns in U.S. dollars.)

China has done a better job at containing and controlling the virus outbreak than the U.S. and its economy has recovered faster and stronger. The Chinese economy has become too big to ignore from an investment standpoint, demonstrated by the strength of its equity market during the global pandemic.

From the perspective of a Canadian investor, emerging markets today offer sector and regional diversification, much more so than they did a decade ago. As a proof point, the correlation between the two markets was 0.91 ten years ago while today it is 0.78. (Five-year correlation between the MSCI Emerging Markets Index and the S&P/TSX Capped Composite Index, Morning Star Direct, October 30, 2020.) And the growth potential that emerging markets offers gives Canadians another region to look to for growth solutions, beyond the U.S. An added benefit is that the growth is offered at attractive valuations. Valuations are historically lower in emerging market economies, especially versus more developed nations whose valuations are arguably stretched right now given the amount of economic uncertainty. The price-to-earnings ratio (P/E) of the S&P 500 Index is 28.4, while the P/E of the MSCI EM Index is 22.6 (Source: Bloomberg, November 27, 2020.)

Emerging Markets and ETFs

An ETF is a great tool to gain access to emerging markets. The MSCI Emerging Markets Index is over 700 securities trading on more than 20 different foreign exchanges, all in different currencies and in different time zones. The easy-to-use, low cost and liquidity benefits of an ETF allow investors to add this entire asset class to their portfolios, in a single trade on a Canadian exchange. There are over 20 different emerging market equity ETFs trading in Canada today, so Canadians have a lot of options. The most widely used benchmark for tracking EM equities is the MSCI Emerging Markets Index, which has over a trillion dollars in active managers benchmarking to it. (Source: MSCI, October 30, 2020.) The BMO MSCI Emerging Markets Index ETF (ticker: ZEM) tracks the MSCI EM index and is the largest emerging markets ETF in Canada with $2.3 billion in assets (Source: BMO Global Asset Management, November 30, 2020.) Some EM ETFs use different index providers and different index construction: some are more tiled to small caps, others have different regional exposures (the inclusion of South Korea is debated, and while MSCI includes it as an emerging market economy, other index providers do not). There are even more EM ETFs which offer targeted exposures to a single country, for example China or India. The use of a broader EM exposure, using an ETF which captures all EM countries, provides an entire basket of economies which may have different market drivers.

Being aware of the global investment universe provides investors more options and more opportunities than concentrating on a specific region or market. As Canadian investors, looking to emerging market economies offers further growth opportunities in addition to North American equities, addresses home bias in portfolios and ultimately creates a more diversified portfolio. As emerging markets evolve, Canadian investors should take a renewed interest in this asset class to seek out long term growth opportunities, which are available to them right at home by using ETFs to gain access to these foreign markets in a highly liquid and low cost solution.


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