The Emerging-Market Rally Is Really Just About Tech Shares

Home-market bias remains one of the great inefficiencies in many portfolios. For example, even though almost half of all U.S.-listed exchange-traded funds are dedicated to foreign stocks and bonds, some 67 percent of their total assets are invested in U.S. stocks and bonds.

There's a relatively simple explanation: American investors are so accustomed to U.S. technology companies dominating the world stage that we think owning Apple/Google/Amazon/Facebook is the same as a well-stamped passport in terms of exposure to international markets. Tech stocks are the single largest weighting in the S&P 500, after all, and they have worked well in 2017.

But the performance of emerging markets this year shows how this home-market bias is a lost opportunity. In dollar terms, the MSCI Emerging Markets Index is up 34 percent, compared with 16 percent for the S&P 500 Index. As it always does, capital has followed performance, with EM ETFs attracting $34 billion in 2017.

How did EM become global market darlings? The answer is not in the old playbook of export-driven growth and rising middle classes. The real driver of performance is one U.S. investors will recognize quite readily. The MSCI EM Index is remarkably tech-heavy, with a 29 percent weighting, topping the S&P 500's 25 percent. To frame this level with some other indexes American investors know well, the Russell 2000’s weighting to technology is 17 percent, which is on par with financials, and the Dow Jones Industrial Average’s 18 percent exposure.

Another point to consider: EM tech stocks with the largest weightings in the index make large-capitalization U.S. tech stocks look downright slouchy, even though the hometown favorites are up an average 30 percent in 2017. Here are the top five holdings in the MSCI EM Index with their year-to-date weightings and performance:

Despite these gains, EM valuations are still attractive, which is not something you can say -- with a straight face, anyway -- about U.S. equities. Based on recent work by Lazard, EM price-to-earnings multiples stand at 12.6 times forward-year estimates, versus 18 times for the S&P 500. And while EM tech stocks trade at a premium of 14.5 times next year earnings, their expected earnings growth rate is greater than 20 percent.