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BlueStar warns of lack of diversification in emerging market indexes

‘How diversified are emerging market indexes?’ asks Steven Schoenfeld (pictured), founder and CIO of BlueStar Indexes. He believes that there is an elevated level of risk in many emerging market indexes as they are less diversified than many investors realise.

BlueStar Indexes has USD650 million in assets and more than 30 live indexes, with the biggest areas of growth across their Thematic Tech index family, especially their first-mover 5G communication indexes and their family of Israeli equity and fixed income indexes.

Their latest launch is an emerging market risk-controlled index, designed with the input of Schoenfeld and his colleagues who have had extensive experience in the sector – in Schoenfeld’s case, since 1992 when he worked on the first investable emerging market index at the IFC/World Bank.
“The dominant benchmarks for institutional investors in emerging markets are those from FTSE, MSCI, and S&PDJI, which acquired the original IFC Index family,” Schoenfeld says. “We have tracked the evolution of these indexes over the years but starting early this year, the concentration risk has become more extreme than in the past.”
This was the driver for BlueStar to launch its own risk-controlled index, designed not to eliminate risk but to ameliorate and attenuate the risks that are inherent in the standard broad-based indexes, Schoenfeld says.
“The biggest risk is that one or two of the top-weighted countries experiences an economic crisis and has a dramatic decline,” he explains, saying that investors in an emerging market ETF with 25 countries in the portfolio might think they are well diversified. “But the facts don’t bear that out,” he says.
The top five countries in the existing index are now over two-thirds of the weight across the major indexes. In addition, all three of the major indexes have added in China A Shares additions over the course of this year which has substantially exacerbated the dominant weight of China.
“Going back to the nineties, the top weighted countries in the emerging markets indexes were as diverse as Mexico, Taiwan, South Africa or Malaysia. All experienced some sort of crisis which triggered a market drop from between 30 to 50 per cent,” he says, adding that with China dominating major emerging market indexes, a drop of that nature would be devastating to the overall performance of the benchmarks and the ETFs that track them.
“The other side of the equation is that the individual stocks include an unprecedented anomaly of large individual companies that are bigger than many of the countries in the index.”
Companies such as Alibaba or Tencent represent over 4 per cent of the weight of the big emerging market indexes. “They are bigger than the bottom 10 countries,” Schoenfeld warns.
“It means that for those investors who want broad and diversified exposure to emerging market for their potential to deliver superior economic growth, they need to be more diversified across the countries, sectors and companies,” he says.
“While you won’t want to exclude any company or country, you should look at the concentration risk.   Therefore, BlueStar has applied our deep emerging market experience in restructuring the idea of how you weight companies, sectors and countries in an index in order to provides broad exposure to this asset class but attenuate the concentration risk.
“It is a risk-controlled index, structured for diversification and to rebalanced annually to capture the mean-reversion tendency in Emerging Markets. 
The rebalancing means that the index is systematically buying losers and selling winners amongst all the stocks, sectors and countries, resetting back to the model weights, adding a major element of risk control.”
Schoenfeld is talking with issuers and institutions in the US, Canada and Israel about launching an ETF or index fund, and hopes by the first quarter of next year to have one or more products tracking the BlueStar new emerging markets index.

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