The latest AI-driven euphoria, led by big tech names that include NVIDIA, has dominated investment sentiment in the post-COVID era. Of course, many investors know that this has driven the U.S. equity market to an all-time high, stretching valuations to an extreme level (U.S. CAPE is at the 98th percentile of historical observations!). However, when we look around the globe, we can find parallels in other markets, surprisingly, some of which are in EM markets.
Looking at the trailing 5-year returns of EM markets, there are two that stand out: Taiwan and India. Taiwan has returned more than 20% per annum, largely driven by a chip company (TSMC) that represents over 20% of the Taiwanese market ETFs (sound familiar?). India, with a surge in participation from both institutional and retail investors, has seen its market rise about 17% per annum. Both markets have far outpaced other EM markets and the EM benchmark basket, which provided 6% returns per annum over the same 5-year period.
Valuation Dispersion Between EM Markets
Current CAPE ratios suggest that most EM markets are fair or undervalued; however, with their outsized recent returns, both Taiwan and India now have valuations that appear to be stretched to extremes. With CAPE values at the 91st and 98th percentiles for Taiwan and India, respectively, mean reversion could provide return headwinds for these markets, according to Research Affiliates models. Thus, investors in Taiwan and India may be better suited not to expect a repeat of the recent past.
Building an EM Portfolio that Tilts Away from Expensive Markets
Unfortunately, a passive, market-capitalization-weighted basket of EM markets faces the pitfall of significant exposures to India and Taiwan, as these two markets represent the second and third largest markets within the emerging markets (China is the largest).
Through the Research Affiliates Asset Allocation Interactive (AAI) portfolio build tool, we can instead construct a custom EM portfolio that tilts away from expensive markets. We can start with market-capitalization weighting and make small adjustments to underweight, expensive, and overweight fair or undervalued markets. In addition, we can also minimize the effects of country-specific idiosyncratic risk by limiting concentration to one country.
Compared to the benchmark EM basket, the custom portfolio reduces the valuation headwind, turning it into a tailwind. Most importantly, by incorporating a systematic process that rebalances the portfolio to these allocations, investors may be able to expect an additional 1.8% per annum tailwind. These tilts increase the expected risk at the margin and of course, investors should expect some tracking error to the benchmark basket, but the return-risk tradeoff is attractive.
Investors who would like to conduct further research and explore building custom portfolios are invited to use our comprehensive AAI tool on our website. It provides all the charts and information in this article and is an excellent resource, as well as so much more.
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