Emerging markets are an important asset class that include major countries with massive populations like China and India. Emerging market investments have been accessible for decades, but they’ve often included state-owned enterprise (SOE) holdings — whether you’ve wanted them or not. Maybe you didn’t. State Owned Enterprises are notoriously inefficient, often conflicted and sometimes even overtly corrupt. It’s possible to invest in emerging market funds without these SOEs. Let’s take a deeper look.
Separation has begun
A majority of SOE holdings in emerging markets come from China, Russia and Brazil, with the leading sectors being financials and energy. A move is underway to weed them out of ETFs, but it’s just getting started. Given the choice, I would not invest in companies like China Construction Bank, China Mobile, Sberbank, Gazprom and Petrobras, among others. Many of these companies have obvious well-known examples of fraud and corruption that would not pass the standards of US rule of law. That’s where the inefficiency ultimately originates.
I expect that the two biggest emerging market ETFs, VWO (Vanguard) and EEM (BlackRock) will consider SOE filters in 2020. XSOE by WisdomTree is leading the way on this non-SOE investment thesis. This would be a big step forward but it’s a natural next step for those providers to consider. Until then the expectation is that non-state owned enterprise companies will carry the performance (as they have).
Why the distinction is important
There are five years of actual ETF performance with one ETF that excludes SOEs. Already we can see outperformance when we exclude the SOEs. I believe the performance trend will continue due to popular demand both from investors and from governments not wanting to endorse inefficient investments. The United States is leading the way right now in trying to exclude Chinese SOEs from as many areas of business as possible. The passage of the Magnitsky Act in 2012 has also made it harder for criminally inspired Russian companies to operate publicly.
A note on expenses
Non-SOE Emerging Markets investments are available with low cost-efficient expense ratios. And they can be traded for free now that commissions have been reduced to zero. If you want to get ahead I recommend starting with a discussion with us about the tax and allocation impact within your portfolio as a whole.
Know what you own
The SOE issue is another great reminder that it’s essential to know what’s really in your investment portfolio. ETFs with similar names may hold very different securities, especially in emerging markets where potential holdings vary widely across different countries (China vs. Poland vs. Argentina). It’s crucial to look under the hood and see what’s actually in there. Understanding what’s in every investment is an obsession of ours at Osbon Capital. We’d be happy to share what we’ve learned.
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