Capturing Emerging Markets' Strength Without Excessive China Exposure

"I don't understand your emerging market portfolio strategy." So says a reader who does not understand how I can have no China. He says I have cost my clients dearly.

From the top down, emerging markets is an asset class that has a place in diversified portfolios. Generally speaking, equal weight is somewhere in the neighborhood of 7-8%.

The first step is to assess whether you think overweight, equalweight or underweight is the best posture. Emerging markets have been white hot for several years now. Money is pouring in very aggressively, chasing the great returns.

When I started my site three years ago I was overweight the space, as it was a less popular trade back then. More recently I have chosen to be closer to equal weight because of the huge run and the popularity of the trade. It just seems late to be overweight. If emerging markets double from here in the next 12 month, equal weight would participate very nicely.

From a more bottoms-up approach, PE ratios are much higher than they used to be. I have seen estimates ranging from 15-18 times earnings. A few years ago, PE ratios were in the single digits as a means of compensation for the risk taken. PE ratios are not necessarily helpful to predict what comes next, but in terms of valuation they have become much more expensive. This is the type of thing that could reasonably evolve slowly over time, but the trend in emerging market PEs has not been slow.

So once the over/equal/under decision has been made (and to be clear, for me now the answer is equal-ish), you need to decide what you think is the best way to capture the space. Emerging markets are more volatile than domestic stocks. When you add emerging you are adding volatility. Given my belief that the move is long in the tooth, I don't want to add a lot of volatility relative to emerging.

This leads me to the most common positioning amongst clients which is one broad-based ETF and one stock from Brazil (some clients have one or two other items depending on the circumstance of that client). The broad based ETF is up 50% YTD (a little better than roughly the roughly 40% that EEM is up) and the common stock from Brazil is up about 130% YTD.

The one Brazil stock is up more than iShares China (FXI), which is up just under 100% YT - Sinopec (SNP) up just under 100% YTD, Petrochina (PTR) up 80%, China Mobile (CHL) up about the same as my Brazilian stock. No doubt there are smaller Chinese stocks that are up more than 130%, but I do believe the reader's notion that I have cost my clients dearly has been refuted.

If I had held onto a Chinese stock instead of the Brazilian name, it would have been at the same weight as the Brazilian name.

Brazil gets a lot of attention, but China gets a lot more - and I feel the recent action in Chinese stocks is much more dangerous than what is going on in Brazil. As I believe I mentioned the other day, the market caps in some of the Chinese names are huge. What I believe I have done with this decision is get a similar result to the hottest market without being in the hottest market. If China does ever implode, maybe Brazil would drop by a smaller amount?

Oh and of course the broad based ETF I use has a little China in it too. I couldn't figure out how to work this in naturally up above, but I own CHL for one or two clients.

Comments

[jag]

You've just argued that a single Brazilian common stock is a useful proxy for China. Huh??

[RogerNusbaum]

your comment, I believe, is more bottom up. Second paragraph I say "from the top down." Top down is more about how much emerging to own and then trying to figure what you think is the best way to own it.

China across the board is tough for me right now for the risks I mentioned, risks that have not come home to roost yet.

In that context i do not believe I have argued Brazil as a China proxy, I believe I have argued my preferred allocation to emerging. Fair enough if you disagree.