Investing in Emerging Markets

Summary

The video script by Ben Felix, a portfolio manager at PWL Capital, debunks the myth that high economic growth in emerging markets correlates with higher investment returns. Instead, historical data reveals a negative relationship. Felix discusses the risks and nuances of investing in these markets, including economic recovery, diversification benefits, and the impact of market integration. He also highlights the importance of considering costs, factor premiums, and the unique risks associated with negative skewness in emerging markets.

Takeaways

• 📈 The term 'emerging markets' was created in 1981 by the International Finance Corporation to attract foreign investment into developing economies.
• 🌍 Emerging markets constitute about 10-12% of the global free float market capitalization and include approximately 25 countries like China, India, and South Korea.
• 🔍 Contrary to a common myth, economic growth does not necessarily correlate with higher investment returns; historical data shows a negative correlation between the two.
• 📊 High growth expectations and earnings in emerging economies are often priced in, which can lead to lower stock market returns due to earnings being spread across more shares.
• 💡 The economic footprint of emerging markets is larger than their representation in financial indexes due to factors like foreign ownership restrictions and free float weights.
• 📊 Emerging markets are more volatile but offer diversification benefits, potentially due to incomplete market integration and higher local risk factors.
• 💰 The cost of capital in emerging markets is lower, which can lead to more investment and economic growth, supported by empirical evidence from market liberalization studies.
• 📉 Emerging markets have historically underperformed developed markets, with significant periods of negative skewness indicating higher disaster risk.
• 🌐 The integration level of emerging markets is crucial for investors, as it affects diversification benefits and expected returns, with markets becoming more integrated over time.
• 💼 Factor premiums such as value, size, and profitability are present in emerging markets and can offer higher expected returns at different times compared to developed markets.
• 💸 Investors should be cautious about the costs associated with investing in emerging markets, including management fees, trading expenses, and foreign withholding taxes, which can significantly impact returns.

Q & A

Who coined the term 'emerging markets' and when was it first used?

The term 'emerging markets' was coined in 1981 by the International Finance Corporation.

What percentage of the global free float market capitalization do emerging markets currently represent?

Emerging markets make up roughly 10 to 12% of the global free float market capitalization.

How many countries are typically included in the definition of emerging markets?

Emerging markets represent around 25 countries, including major economies like China, Taiwan, India, South Korea, and until recently, Russia.

What is the common myth about the relationship between economic growth and investment returns that the script addresses?

The common myth is that economic growth and investment returns are positively related, meaning that higher growth economies should yield higher investment returns, which the script refutes.

According to the 2014 Credit Suisse Global Investment Returns Yearbook, what was the cross-sectional correlation found between real equity returns and real per capita GDP growth?

The cross-sectional correlation found was negative 0.29, indicating that there is a negative relationship between real equity returns and real per capita GDP growth.

What does the script suggest about the reasons for historically lower stock market returns in countries with stronger economic growth?

The script suggests that expected growth and earnings are priced into high growth economies, and growing profits are spread across an increasing number of shares as new businesses emerge, leading to less earnings per share growth.

How does the script describe the effect of war on the economies and investment returns of war-torn countries compared to non-war-torn countries?

The script describes that while war-torn countries' economies can recover significantly, their dividend growth trails their economic growth by nearly twice as much as non-war-torn countries due to high rates of equity recapitalization.

What is the script's stance on the idea of using expected economic growth as a reason to overweight emerging markets in a portfolio?

The script argues against using expected economic growth as a reason to overweight emerging markets, due to the historical evidence of lower stock market returns in high growth economies.

How does the script explain the concept of 'free float' and its significance in the context of emerging markets?

Free float measures the value of shares available for trading, excluding shares owned by entities like state-owned enterprises. The script explains that free float weights as a percentage of total company capitalization are typically higher in developed markets, affecting how the size of investible capital markets is perceived by foreign investors.

What are the implications of market integration for investors in emerging markets, as discussed in the script?

The script discusses that in a segregated market, assets are priced based on local risk factors leading to higher expected returns, whereas in an integrated market, assets are priced based on their contribution to the risk of the market portfolio, leading to lower expected returns due to diversification benefits.

How does the script address the issue of costs and risks associated with investing in emerging markets?

The script addresses costs and risks by discussing the higher volatility of emerging markets, the potential for disaster risk due to negative skewness, the impact of foreign withholding tax, and the importance of considering the multi-factor structure of expected returns.

What advice does Ben Felix, the portfolio manager at PWL Capital, offer regarding the allocation to emerging markets in a diversified portfolio?

Ben Felix advises that emerging markets deserve a place in a well-diversified portfolio but cautions against aggressively overweighting this asset class in pursuit of higher expected returns, suggesting that free float capitalization weights are a sensible starting point.

Outlines

00:00

🌐 Myths and Realities of Emerging Markets Investing

This paragraph delves into the concept of emerging markets, introduced by the International Finance Corporation in 1981, and their significance in today's global economy. It challenges the common belief that high economic growth directly correlates with higher investment returns, citing studies by Dimson, Marsh, Staunton, and Jay Ritter that show a negative correlation between economic growth and equity returns. The explanation provided involves the dilution of earnings per share growth due to an increase in the number of shares as new businesses emerge. The paragraph also highlights the unique case of China's stock market underperformance despite rapid economic growth and discusses the economic footprint of emerging markets in relation to their representation in financial indexes.

05:00

📈 Diversification and Risk in Emerging Markets

The second paragraph explores the dynamics of market integration and its impact on investment returns. It explains how assets in segregated markets are priced based on local risk factors, leading to higher expected returns due to limited diversification opportunities. In contrast, integrated markets offer lower expected returns due to the diversification benefits they provide. The paragraph also discusses the implications of financial market liberalization on expected returns and economic growth, the potential premium earned by investors in partially integrated markets, and the importance of considering the integration level of emerging markets. Additionally, it touches on the concept of skewness in asset returns, particularly the negative skewness observed in emerging markets, and its impact on portfolio risk and expected returns.

10:02

📊 Historical Performance and Factor Premiums in Emerging Markets

This paragraph examines the historical performance of emerging markets compared to developed ones, noting the underperformance of the former over the full period from 1900 to 2020, with a significant downturn attributed to the post-World War II period. It then presents a more optimistic view from 1960 onwards, where emerging markets have outperformed developed markets, albeit inconsistently. The discussion shifts to the presence of multi-factor premiums in emerging markets, such as value stocks, which have shown substantial outperformance compared to the U.S. market. The paragraph also addresses the higher costs associated with investing in emerging markets, including management fees, trading expenses, and the impact of foreign withholding taxes, especially in registered accounts like RSPs or TFSAs.

15:04

🔍 Navigating the Complexities of Emerging Market Investments

The final paragraph offers insights into the complexities of investing in emerging markets, emphasizing the importance of a cautious approach when considering overweight positions in pursuit of higher expected returns. It suggests using free float capitalization weights as a starting point for portfolio allocation and highlights the benefits of seeking exposure to multiple risk factors within emerging markets. The paragraph also discusses the availability of low-fee ETFs that offer such exposures and the importance of considering the definitions of emerging markets used by different index providers to avoid mismatches in investment products. Ben Felix concludes by advocating for a balanced strategy and invites viewers to engage with additional content on the topic.

Keywords

💡Emerging Markets

Emerging markets refer to the economies of countries that are in the process of rapid growth and industrialization, but have not yet reached the level of developed countries. In the video, they are discussed as investment destinations that represent around 10 to 12% of the global free float market capitalization and include countries like China, India, and South Korea. The script highlights the allure of these markets due to their high economic growth expectations and attractive valuations, but also warns of the associated risks and costs.

💡Portfolio Manager

A portfolio manager is a professional who oversees investment portfolios by making buy and sell decisions for securities in the portfolio. In the context of the video, Ben Felix, a portfolio manager at PWL Capital, is the speaker who provides insights into the complexities of investing in emerging markets and shares his expertise on the subject.

💡Economic Growth

Economic growth is the increase in the production of goods and services in an economy over a period of time. The video challenges the common myth that higher economic growth directly correlates with higher investment returns. Instead, it cites studies showing a negative correlation between economic growth and equity returns, suggesting that countries with strong growth may have lower stock market returns.

💡Investment Returns

Investment returns refer to the profits or losses generated from buying and selling investments. The video discusses the misconception that investment returns are positively related to economic growth. It uses historical data to argue that countries with higher economic growth rates have historically provided lower stock market returns, which is contrary to what many investors might expect.

💡Free Float Market Capitalization

Free float market capitalization is the market capitalization of a company's shares that are available for trading by the public. The script mentions that emerging markets make up roughly 10 to 12% of the global free float market capitalization, indicating the significant size of these markets relative to the global economy.

💡Cost of Capital

The cost of capital is the return that investors expect for providing capital to a company. In the video, it is explained that a lower cost of capital can lead to more investment in projects and economic growth. The script also discusses how financial market liberalization in emerging markets can lead to a decrease in the cost of capital.

💡Volatility

Volatility refers to the degree of variation of a trading price series over time. The video describes emerging market stocks as being volatile, meaning their prices can change dramatically in a short period. This characteristic is important for investors to consider when constructing their portfolios, as it can affect the overall risk and potential returns.

💡Diversification

Diversification is the practice of spreading investments across various financial instruments, industries, and other categories to minimize risk. The script explains that emerging markets can offer diversification benefits to a portfolio, potentially reducing overall risk by not moving in perfect synchronization with developed markets.

💡Factor Premiums

Factor premiums are the additional returns that investors expect for investing in certain factors or characteristics that have historically produced higher returns, such as value or size. The video notes that emerging markets have shown substantial factor premiums, particularly in value stocks, which have outperformed the broader market in these regions.

💡Coskewness

Coskewness is a measure of the asymmetrical risk of a portfolio's returns. The video discusses the concept of negative coskewness in emerging markets, which means that these markets have historically been associated with more frequent extreme negative returns. This negative skewness can command a risk premium, but it also represents a significant risk for investors.

💡Foreign Withholding Tax

Foreign withholding tax is the tax withheld by a country on dividends paid to foreign investors. The script highlights the impact of foreign withholding tax on the returns from emerging market investments, especially in registered accounts where the tax is not recoverable, leading to a reduction in the overall expected returns.

💡MSCI

MSCI (Morgan Stanley Capital International) is a provider of investment decision support tools, including indices that are widely used for creating investment portfolios and tracking fund performance. The video mentions MSCI in the context of its classification of certain countries as emerging or developed markets and the implications this has for investors.

Highlights

The term 'emerging markets' was first used in 1981 by the International Finance Corporation to attract foreign investment in developing economies.

Emerging markets currently represent 10-12% of the global free float market capitalization and include about 25 countries.

Investors are sometimes misled to believe that higher economic growth directly correlates with higher investment returns, which is not supported by historical data.

Studies have shown a negative correlation between economic growth and investment returns, contradicting common investment myths.

High growth economies may have lower stock market returns due to high expectations already priced in and earnings spread across more shares.

War-torn countries can recover economically but may have lower dividend growth due to the dilution from equity recapitalization.

China, despite significant economic growth, has delivered lower stock market returns compared to developed markets.

Emerging markets have a larger economic footprint than their representation in financial market indexes due to investibility restrictions.

Free float weights, which measure the value of shares available for trading, are typically higher in developed markets than in emerging ones.

Emerging market stocks are volatile but offer diversification benefits, potentially due to incomplete market integration.

In segregated markets, assets are priced based on local risk factors, leading to higher expected returns compared to integrated markets.

Lower expected returns in integrated markets benefit the real economy by reducing the cost of capital for businesses.

Investors in emerging markets before full integration can expect to earn a premium as markets liberalize and integrate.

The integration level of emerging markets is crucial for investors, with more integration leading to lower expected returns and higher covariances with the market portfolio.

Emerging markets exhibit a more pronounced negative skew in stock returns, indicating a higher risk of extreme negative outcomes.

Negative coskewness of emerging markets with the MSCI World portfolio suggests a need for higher expected returns to compensate for disaster risk.

Despite underperformance in the past, emerging markets have outperformed developed markets since 1960, but only 42% of the time over 25-year periods.

Factor premiums such as value, size, and profitability are present in emerging markets and can offer higher returns compared to developed markets.

The costs associated with investing in emerging markets, including management fees, foreign withholding tax, and双层 foreign withholding tax, can significantly impact returns.

Index providers may have different definitions of emerging markets, which can lead to discrepancies when mixing investment products.

A balanced approach to investing in emerging markets is recommended, considering their potential for diversification and factor premiums, alongside risks and costs.

Transcripts

- The term emerging markets was coined in 1981

by the International Finance Corporation

as a marketing term to help make the case

for foreign investors investing in developing economies.

Today, emerging markets make up roughly 10 to 12%

of the global free float market capitalization,

representing around 25 countries, including China, Taiwan,

India, South Korea, and until recently, Russia.

Characteristics like high economic growth expectations

and attractive valuations compel some investors

to overweight emerging markets in their portfolios.

But there are some often overlooked facts,

costs and risks that should be carefully considered.

I'm Ben Felix, portfolio manager at PWL Capital.

I'm going to tell you about the intricacies

of investing in emerging markets.

One of the longest running myths in investing

is that economic growth and investment returns

are positively related.

That is if you invest in the highest growth economies

or sectors, you will earn higher investment returns.

The reality is the exact opposite.

This is documented in detail by Dimson, Marsh and Staunton

in the 2014 Credit Suisse

Global Investment Returns Yearbook,

where they find a cross-sectional correlation

of negative 0.29 between real equity returns

and real per capita GDP growth

for 21 countries with continuous stock market histories

from 1900 to 2013.

In a 2012 paper,

titled "Is Economic Growth Good for Investors?"

Jay Ritter found similar results

for 19 primarily developed markets from 1900 through 2011,

with a negative cross-sectional correlation of 0.39.

Ritter also looked at a sample

of 15 emerging market countries for the 24-year period

from 1988 through 2011,

including Brazil, Russia, India and China,

and found a similarly negative cross-sectional correlation

of negative 0.41.

This evidence suggests that countries

with stronger economic growth

have historically had lower stock market returns.

The reasons are probably a combination of expected growth

and earnings being priced into high growth economies,

and growing profits in these economies

being spread across an increasing number of shares,

as new businesses emerge

to meet the demands of a growing economy.

If aggregate earnings grow, but lots of new businesses start

or existing businesses raise new equity capital,

earnings per share growth,

which is what matters for stock returns,

will rise less,

due to earnings being spread across more shares.

An interesting laboratory to observe this effect

is war-torn and non-war torn countries from 1900 to 2000,

as demonstrated by William Bernstein and Rob Arnott

in their 2003 paper,

"Earnings Growth, The Two Percent Dilution."

Bernstein and Arnott show that while war-torn countries

had their economies devastated by war,

within little more than a generation,

their GDP caught up to, or surpassed,

the GDP of non-war-torn countries.

Despite their impressive economic recoveries,

war-torn countries' dividend growth

trailed their economic growth measured by per capita GDP

by nearly twice as much

as the non-war-torn countries in the sample.

The explanation for the larger gap

is that war-torn countries had to go

through a high rate of equity recapitalization.

New companies needed to form

and existing companies needed to raise new capital

for the economic recovery,

diluting the benefits of economic growth

for existing shareholders.

A nice anecdotal example is China.

Despite massive economic growth

by any measure that you can think of,

the Chinese stock market has delivered

substantially lower returns

than international developed markets.

While expected economic growth may not be a reason

to overweight emerging markets,

there are some other good arguments.

Emerging markets have a much larger economic footprint

measured by things like GDP population and land mass

than their weight in financial market indexes.

One of the reasons for this is that index providers

typically focus on the investible market

from the perspective of a global investor,

meaning that foreign ownership restrictions

in some countries reduce the size

of their investible capital market

from the perspective of a foreign investor.

China's A-Shares are a good example.

MSCI excluded them until 2018,

and even now, only allocates 20%

of their actual free float capitalization in their indexes.

The other big contributor is the use of free float weights.

Free float measures the value of shares

that are available for trading,

excluding shares owned by, for example,

state-owned and enterprises and company founders.

Typically, free float weights as a percentage

of total company capitalization are much higher

in developed markets than in emerging markets.

There are some other important details to know

about how this asset class fits into a portfolio.

Emerging markets stocks tend to be volatile,

but they also tend to have diversification benefits

with respect to the developed market portfolio.

One of the reasons for this diversification benefit

may be incomplete market integration.

An integrated market is fully open to foreign investors

and for domestic investors to own foreign assets,

while a segregated market is completely closed.

Think about an investor in a country

who cannot invest outside of their own country,

and no companies in their country

can raise capital from foreign investors.

In that case, only local economic risks matter

in determining an asset's expected return,

and expected returns will tend to be higher

since investors are unable to diversify their risk.

An investor in a country like Canada, on the other hand,

where you can invest globally,

will assess expected returns based on the asset's

risk contribution to the market portfolio,

rather than on the local risk factors.

In a segregated market,

assets will be priced based on local risk factors,

and expected returns will tend to be higher,

whereas in an integrated market,

assets will be priced based on their contribution

to the risk of the market portfolio

and expected returns will tend to be lower

due to this diversification benefit.

Lower expected returns sound bad,

but for the real economy of an emerging market,

lower expected returns are great.

The expected return is the cost of capital

that the businesses listed on the stock exchange

used to assess projects.

A low cost of capital should mean more investment

in projects and more economic growth.

This is confirmed empirically in the 2000 papers

"Foreign Speculators and Emerging Equity Markets"

and "Equity Market Liberalization in Emerging Markets."

When countries liberalize their financial markets,

their expected returns tend to fall,

and GDP growth tends to increase.

The other implication here

for investors in emerging markets

is that if you are invested before complete integration,

you expect to earn a premium as expected returns fall

and prices rise as the market liberalizes and integrates.

Of course, this premium can't be predicted or timed,

and it's definitely not guaranteed.

A partially integrated financial market can deliver

a diversification benefit and a high expected return.

But as emerging markets liberalize

and begin to integrate allowing foreign investors in,

their expected return should fall

or their co-variances with the market portfolio

should increase as foreign capital

absorbs the diversification benefit.

An asset with a low covariance with the market,

and a high expected return would be a free lunch,

and its price would quickly be bid up,

meaning its expected return would fall

to the point that its expected return

matches its risk contribution to a diversified portfolio.

The extent to which emerging markets are integrated

is another important question

for investors considering this asset class.

Empirically, based on the paper

"What Segments Equity Markets?"

emerging markets have become more integrated over time

but are still more segregated than developed markets.

This implies an ongoing diversification benefit.

Additionally, while correlations between developed

and emerging market returns have increased since the 1980s,

they have remained imperfect at around 0.8.

Emerging markets have another unique property

that needs to be considered.

Looking only at the mean and variance

of an asset's contribution to a portfolio

assumes that the returns follow a normal distribution,

ignoring an important statistical measure called skewness.

Skewness measures the asymmetry of a distribution.

Aggregate stock market returns

are negatively skewed in general,

meaning that returns are generally

more positive than negative,

but there are infrequent extreme negative.

Emerging markets exhibit

an even more pronounced negative skew

than stock markets in general.

We can think about this as disaster risk.

Similar to volatility, we don't actually care

about the skewness of an individual asset on its own.

We care about the contribution of the asset's skewness

to the skewness of the overall portfolio,

a measure called the coskewness.

As it turns out, as documented

in "Drivers of Expected Returns in International Markets,"

emerging markets have historically had negative coskewness

with the MSCI World portfolio,

meaning that adding them to the portfolio

makes the overall portfolio's skewness more negative.

This property, negative coskewness,

should increase the expected return of an asset.

Negative skewness is not something

that most investors want in their portfolio

so they need a higher expected return to compensate.

In "Conditional Skewness and Asset Pricing Tests,"

we learn that both in the theory and the empirical data,

negative cost skewness does in fact command

a meaningful risk premium.

Maybe this sounds enticing for any risk-seeking investor,

another priced risk,

but the type of disaster risk

that has historically shown its face in emerging markets

might make you think twice.

looking at developed and emerging market portfolios

from 1900 through 2020,

it may be surprising to see that emerging markets

have trailed developed markets for the full period.

This underperformance is largely due

to a disastrous period from 1945 to 1949.

Japan lost 97% and Chinese markets were closed in 1949,

following the communist victory.

There were other poor performers,

but these examples demonstrate the extreme disaster risk.

It's easy to brush this off

and say that this type of collapse couldn't happen today.

But emerging markets generally have greater political risk,

less developed stock markets and tighter control

on foreign investors than developed markets do.

Disaster risk may be showing up in Russia right now.

Russia was previously classified as an emerging market,

and at the time of recording, has been demoted

by index providers to a standalone market,

due to its stock market no longer being investible.

There is a risk premium

for that left tail risk for a reason,

but it's important to realize that negative skewness

may not be as easy to ride out

and recover from as volatility.

Changing the start date to 1960,

emerging markets have outperformed developed markets.

But looking at 25-year rolling periods from 1900 to 2020,

emerging markets have only beat developed markets

42% of the time.

The multi-factor structure of expected returns

that exist in developed markets

also seems to be present in emerging markets.

Emerging markets factor premiums have been substantial

and have shown up in the recent period,

where they've been largely absent in developed markets.

Value is a good example.

That is stocks with owe prices relative

to their business fundamentals, like book value.

Typically they outperform,

but in the U.S. for the 20 years ending December, 2021,

value stocks have trailed the market

by a painful 1.69% per year,

leading many people to claim that value is debt.

Meanwhile, over the same period, emerging markets value

has beaten the emerging markets index by 1.91% per year,

and beaten the U.S. market by 2.77% per year.

Other factor premiums like company size and profitability

have also been positive in emerging markets.

Emerging markets are volatile,

but they offer diversification

to developed markets portfolios.

They also have high expected returns,

but some of those high expected returns come at the cost

of negative skewness, which can really hurt,

even if you do have a long-time horizon.

Factor premiums exist in emerging markets

and have historically shown up at different times

than U.S. and developed market premiums.

The last thing to consider is costs.

Comparing the iShares Core MSCI

Emerging Markets IMI Index ETF, XEC,

with the iShares Core MSCI EAFE IMI Index ETF, XEF,

which is a developed markets index,

the management fee and trading expense

add roughly five basis points for emerging markets.

That's not too bad,

but the bigger issue is foreign withholding tax.

When a stock in a country

pays a dividend to a foreign investor,

the source country will often withhold some tax.

This withholding tax is typically recoverable

in a taxable investment account for a Canadian investor,

because it can be used as a credit

against Canadian taxes owing.

But in a registered account, like an RSP or a TFSA,

the foreign withholding tax is not recoverable.

There are a couple of issues here.

Emerging market stocks tend to have higher yields

than developed market stocks.

This means that more of your returns

come in the form of foreign dividend income.

That alone increases the cost of ownership

in both taxable accounts, due to taxes on foreign dividends,

which are fully taxable,

and in non-taxable accounts,

due to unrecoverable foreign withholding tax.

On top of that, the withholding tax rate

from emerging markets countries tends to be higher.

The result is generally higher income tax

and withholding tax costs for emerging market stocks.

But it actually gets worse.

If you own a Canadian-listed ETF

that owns a U.S.-listed ETF of emerging market stocks,

rather than owning the underlying stocks directly,

you get hit with a second layer of foreign withholding tax.

In Canada, there are no Canadian domiciled emerging markets

index funds targeting large, mid, and small caps

that hold securities directly.

XEC from iShares and VEE from Vanguard

both hold their U.S.-listed equivalent.

For example, the total unrecoverable

foreign withholding tax cost for owning XEF,

which holds developed market stocks directly,

in a taxable account, can be estimated at 0%,

since foreign taxes are recouped

if they can offset Canadian taxes,

while XEC, which holds a U.S.-listed ETF

of emerging market stocks gives up more than 0.3%

on the layer with holding tax

paid from foreign companies to the U.S.-listed ETF.

In a TFSA account, the difference is even bigger

with XEF losing a little more than 0.2%

and XEC losing more than 0.7%.

These additional fees and costs add up

and they weigh on the expected returns of this asset class.

One way around the withholding tax issue

is to own an ETF like ZEM,

which generally hold stocks directly,

but does not at small cap stocks.

The tradeoff here is between giving up

higher expected returns on smaller companies

for lower withholding tax burden.

The dimensional funds that my firm, PWL Capital,

uses in client accounts

also hold emerging markets stocks directly.

Some additional costs are not an issue,

if we expect emerging markets

to deliver a large premium over developed markets.

But as we've seen, that's not a sure thing,

especially if the deep left tail

decides to show up in your investment lifetime.

I don't think it's sensible to run

a portfolio optimization process based on things

like expected returns, covariances and coskewness

to find the theoretically optimal allocation

to emerging markets.

The output of that type of optimizer

is highly sensitive to its inputs,

and we only have past or expected inputs.

There's a good chance that the future will look different,

and our theoretical optimal portfolio will be suboptimal.

A quick final point is that not all index providers

have the same definition of emerging markets.

This is important because mixing and matching

investment products from different providers

can lead to problems.

The most significant example is South Korea,

which is the second largest emerging market

by market capitalization after China,

if you follow MSCI's indexes.

But FTSE Russell classifies it as developed.

This means that if you buy

a developed market's product tracking an MSCI index,

and an emerging market's product tracking a FTSE index,

you will have excluded South Korea entirely.

The other example is Poland,

which MSCI classifies as emerging

and FTSE classifies as developed.

Applying some common sense, I think emerging markets

deserve a place in a well-diversified portfolio,

but I would be cautious applying an aggressive overweight

to this asset class in pursuit of higher expected returns.

The free float capitalization weights

that most index providers use

are probably a sensible starting point.

If possible, seeking exposure to multiple risk factors

in emerging markets makes sense.

Fortunately, for investors,

ETFs from dimensional fund advisors and Avantis

are now offering these exposures in low-fee products.

Thanks for watching.

I'm Ben Felix, portfolio manager at PWL Capital.

If you enjoyed this video, please share it with someone

who you think could benefit from the information.

We also discussed this topic in episode 191

of The Rational Reminder Podcast,

and I would love it if you checked it out.

(upbeat music)