Global-equity funds often benchmark themselves against the MSCI World Index. This index consists of 1,646 mid- and large-cap stocks across 23 countries and covers approximately 85% of the market capitalisation in each country. Although this seems to be a fair representation of the global opportunity set, one arguably crucial region is missing: emerging markets.
While emerging-markets countries are not part of the MSCI World Index, global-equity fund managers often have the flexibility to dip into these to get direct exposure to their fast-growing, but also tricky, economies, either to boost returns or for diversification purposes.
Limited Direct Emerging-Markets Exposure
We analysed 112 actively managed open-end and closed-end funds and passively managed exchange-traded funds that carry a Morningstar Analyst Rating. Most of the funds in this sample invest directly in emerging markets, albeit often at the margin.
The median allocation to the region as at the end of March 2017 was 3.3%. There were 21 funds that had no direct exposure to emerging markets. Of this subset, just nine funds had no direct exposure over the past three years.
For most global equity funds that invest directly in emerging markets, the allocation typically doesn’t rise above 5%. Just a handful of funds invest a significant portion of their assets in developing countries, with direct exposures exceeding 20% as per the end of March 2017.
An example is Murray International (MYI), a Gold-rated closed-end fund that leverages Aberdeen’s global-equity team. The fund’s benchmark-agnostic approach enables manager Bruce Stout to invest where he sees opportunities and value.
Exposure to emerging markets has been constant at around 30% of the portfolio. Because of the quality focus, China and Russia have been unappealing candidates, given Stout's concerns on corporate governance and government interference. Instead, he has preferred India, Indonesia, and Brazil.
Analysing direct emerging-markets exposures of global-equity funds indicates that the allocation to the region is typically limited. However, traditional methodologies that classify a stock as belonging to a particular country or region do not always give the full picture.
Traditional classification methods often categorise companies based on where the stock is listed, where the company was founded, or where its headquarters are based. However, this approach does not necessarily reveal the economic exposure of a company to a particular country or region, which is more relevant from an investor point of view.
Mining company BHP Billiton (BLT), for example, has a listing on the London Stock Exchange but is highly dependent on economic conditions in emerging countries and China in particular, while on the other hand, it operates its mines and petroleum activities in Australia, the United States, and South America.
A More Sophisticated View
To go beyond the discrete geographic classification of stocks, investors could try to analyse fundamental data such as revenues or earnings splits in order to reveal the underlying regional exposure of a company. To better capture portfolio exposures to multiple geographies, the Morningstar Global Risk Model estimates the partial economic exposure of each portfolio to seven regional Morningstar benchmarks: developed America, Europe, Asia and emerging Americas, Europe, Asia, and Middle East & Africa.
Running the Morningstar Global Risk Model to analyse the economic exposures of global-equity funds to the seven Morningstar regions reveals some interesting results and leads to different conclusions compared with the traditional classification methodology.
As of the end of March 2017, the risk model estimates that all global-equity funds in our sample had some economic exposure to emerging markets. Even more striking, the median exposure to developing countries was 8.9%, almost triple the exposure calculated under the traditional methodology.
For funds that had no exposure to developing countries when using traditional classifications, the risk model estimates a median economic exposure of 4.7%. For 48 funds, more than two fifths of the sample, the exposure to emerging regions measured by the risk model was larger than 10%. Although the median exposure to emerging markets increased when using the risk model, we also found lower emerging-markets exposures compared with the traditional methodology for 13 funds.
Zooming in on individual funds, we observe significant differences in emerging-markets exposure for some funds in our sample. The largest difference was found for the iShares Stoxx Global Select Dividend 100 ETF (ISPA). Traditional regional classification indicates that the ETF had just 0.6% invested directly in emerging markets, but the risk model reveals that its estimated economic exposure amounts to a whopping 21.6%.
Gold-rated Veritas Global Equity Income is also among the funds that show a large difference in emerging-markets exposure through the risk model, as 13.8% of its returns are driven by emerging markets while it had no direct investment in the region according to the traditional classification methodology.
Here, for example the investments in HSBC (HSBA) and British American Tobacco (BATS) are driving economic sensitivity to emerging markets. The table below shows the five funds that have significant differences between the traditional and risk model emerging-markets exposures.
