Many investors turn to emerging markets to diversify their portfolios away from developed market indices that are heavily dominated by the US. Today, however, that approach is only partially effective. The MSCI Emerging Markets Index is no longer the counterweight to the technology-driven US equity market that some investors still consider it to be.
Taiwan and South Korea together account for almost half of the index. China also represents a significant share and its recent market performance has been heavily influenced by technology companies. As a result, a substantial portion of the emerging markets index is now linked, directly or indirectly, to the broader artificial intelligence (AI) theme.
This is not necessarily a negative. On the contrary, Asian emerging markets provide access to different parts of the AI value chain than the US market. While US equities are dominated primarily by chip designers, platform companies and hyperscalers, Taiwan and South Korea are home to some of the world’s most important producers of semiconductors, memory chips and technology infrastructure.
Emerging markets can therefore still provide diversification, but increasingly within the AI ecosystem rather than away from AI altogether.
This is also where concentration risk emerges. Investors who already have significant exposure to major US technology stocks through a global equity index and then add a market-weighted emerging markets ETF may achieve less additional diversification than they expect.
That does not mean investors should turn their backs on the AI cycle. We continue to believe the structural trend remains intact and that we are closer to the beginning than the end of this development. But even a compelling long-term investment thesis does not justify allowing a portfolio to become overly dependent on a single theme.
Looking beyond emerging markets as a bloc
Investors should therefore increasingly avoid viewing emerging markets as a homogeneous asset class. Individual countries differ substantially in their economic structures, growth drivers, sector weightings and exposure to the global technology cycle.
A more targeted allocation – effectively the ‘disaggregation’ of emerging markets – can help investors capitalise on these differences more deliberately.
India is a good example. The country combines several long-term growth drivers: a young and growing population, rising incomes, a high share of domestic consumption, extensive infrastructure investment and advanced digitalisation.
These are complemented by reforms, investment incentives and efforts to integrate India more deeply into global supply chains as a manufacturing hub.
Technology also plays an important role in India, although in a broader sense than the conventional AI narrative. The emphasis is more on software, IT services, digital payments and the wider modernisation of the domestic economy.
This gives investors exposure to technology-driven growth without relying on precisely the same forces that dominate US and North Asian equity markets.
Brazil, by contrast, is almost the ‘anti-Nasdaq’. Information technology represents only a small proportion of the Brazilian equity market. Instead, the market is dominated by banks, energy, materials and commodity-related companies.
Brazil therefore offers exposure to long-term themes including agricultural commodities, food, energy, metals and certain strategically important raw materials. These companies often respond to different economic, inflation and commodity-price cycles from those driving the major US technology companies. This is precisely why Brazilian equities can potentially serve as a genuine diversifying component within a global portfolio.
Different countries, different risks
Of course, investing in individual countries brings its own risks. In Brazil, these include political intervention, the influence of state-controlled companies and dependence on commodity prices.
India, meanwhile, is not attractively valued across all segments following its strong performance in recent years and, as a major energy importer, remains vulnerable to higher oil prices.
Diversification, therefore, does not mean eliminating risk. It means combining different sources of risk rather than concentrating exposure around the same underlying drivers.
Alongside single-country strategies, fundamentally weighted or factor-based emerging markets indices can provide another option. Strategies focused on quality, valuation or dividends may reduce, to some extent, the dominance of the largest technology companies. They do not, however, replace the fundamental allocation decision: which countries, sectors and economic drivers does an investor actually want to own?
Diversification lies beneath the index
The key point is that an emerging markets index is no longer an automatic diversifier. Investors buying emerging markets simply as a complement to a global equity index should look more closely at what they are actually adding to their portfolios.
The true diversification potential of emerging markets comes not from the label itself, but from the considerable differences between the economies within it. India and Brazil illustrate just how broad that spectrum can be — and why taking a more targeted approach to individual emerging markets may prove increasingly worthwhile.
Marcus Weyerer is director of ETF investment strategy at Franklin Templeton. The views expressed above should not be taken as investment advice.