Investors with high allocations to emerging markets are not really diversifying their portfolio from their domestic peers and particularly technology stocks, according to Artemis’ Simon Edelsten. 
The manager of the five FE Crown-rated Mid Wynd International Investment Trust said while emerging market and technology stocks were among the best performing sectors in 2017, they will struggle in a rising interest rate environment – something that could be on the horizon this year.
Yet investors could be forgiven for buying global funds with exposure to both under the assumption that they diversify one another.
“I think the problem you have is people believe emerging markets are not correlated with global growth stocks,” he explained. “As Jim Slater once said, ‘the biggest risks are that you don’t know the risks in your portfolio.’
“And the problem people have with global equity funds is that they have two or three themes and say they are different but the balloon goes up and they all come down together.”
One misconception, he said, was particularly dangerous for investors is the idea that both emerging markets and technology stocks are separate themes.
Indeed, as the below chart shows, the average IA Technology & Telecommunications fund has an r-squared ratio – which indicates how closely correlated a fund is to an index – of 0.73 over 10 years. The average IA Global Emerging Markets fund has an r-squared of 0.68. Values of 0.7 or more suggest that a fund’s behaviour is closely linked to a benchmark.
Rolling r-squared ratio of sectors vs MSCI World over 10yrs
Source: FE Analytics“Emerging markets and tech – which people don’t think of as being correlated – unfortunately can be,” said Edelsten. “They don’t have to be but they can be.”
The simple way of looking at both sectors is that they are what people call ‘risk-on assets’ i.e. they perform well when there is more investor risk appetite and perform poorly when investors are looking to be more cautious.
“If [for example] we wander in one day and there are – shock horror – two sets of non-farm payroll figures on the trot that are a bit higher than expected after three years of being lower than expected, then we are back to 2015 with people worrying about the rate cycle,” he explained.
“What happens then is the TMTs [technology, media & telecoms companies] sell off and the emerging markets sell off – and actually in 2015 they sold off faster.”
As the below chart shows, while technology stocks performed well over the year on the whole, for the first nine months of 2015 they moved in-line with emerging markets before recovering strongly in the final quarter as investors became less fearful of a rapid interest rate cycle and became more concerned about a potential slowdown in China.
Performance of indices in 2015
Source: FE Analytics
“There is no point in people saying they were surprised emerging markets went down at the same time as tech – they have almost every time before,” Edelsten said.
“Even if you went back to 1998-2000 and what people call the ‘TMT bubble’, it was a TMT bubble but also with the Tiger economies [of south-east Asia] blowing up.”
He said that while some may argue the two issues were unrelated, they were not. Indeed, the removal of capital from the system in the run up to the bubble led to a credit tightening cycle that affected both sectors.
During this time companies in the technology sector with lots of debt on the balance sheet and a lack of tangible earnings found their funding disappeared.
“You can’t carry on running Tesla at a loss and making Netflix programs but giving them away at a loss every year because suddenly the money disappears and these shares go to nothing because they can’t look after themselves,” Edelsten said.
“And, lo and behold, at exactly the same time overstretched Tiger economies also didn’t attract global flows effectively.”
Additionally, in 2008 when global developed equities were hammered by the global financial crisis, emerging markets fell as hard as their peers.
“They didn’t have a banking crisis but there was no protection in being long emerging markets,” the fund manager said.
Performance of indices from January 2007 to 2009
Source: FE Analytics
As such, investors should concentrate on what they are using for diversifiers in their portfolio and should scrutinise global funds that are playing the same themes in different ways but passing this off as diversification.
“We have about nine different themes and some of them are a bit more growthy than others so we create little buckets and run r-squareds,” he said.
“Emerging market consumer – which we have made good money out of this year – is just as correlated to the growth themes as anything else. For example, if China slowed, automation demand would slow and tourism would slow.”
However, he makes sure areas such as US healthcare, high quality assets and bank regulation themes adequately diversify the themes that appear to overlap.
However, he admitted that even these are historic and have taken place during one of the longest bull markets in history.
“All sorts of things might be different in a bear market and then you just have to use your experience and what you remember from previous downturns,” Edelsten said.
Since Artemis won the investment mandate for the Mid Wynd International Investment Trust it has delivered a total return of 98.84 per cent, compared with a gain of 76.35 per cent for the average global investment trust, and a 70.48 per cent return for the MSCI AC World benchmark.
Edelsten manages the £170.9m global equities trust, which aims to deliver both capital and income growth, alongside Alex Illingworth and Rosanna Burcheri.
The trust has a yield of 0.98 per cent and ongoing charges of 0.67 per cent, according to data from the Association of Investment Companies. It is 2 per cent geared and is currently trading at a premium of 2.7 per cent.