Hu’s number one? Well, it depends who you ask.

Written by John Osbon on February 9, 2011

Quick, what’s the largest emerging market in the world?  Most people would say China, and measured by gross domestic product that’s clearly the case, by a wide margin. But for investors Brazil is a rising power with a bigger than expected presence in emerging market index funds.

If you poke around under the hood of the leading emerging market index fund (Vanguard’s $60 billion VWO), you’ll find China and Brazil neck and neck at the top. Chinese companies comprise about 17 percent of the asset value of the fund, with Brazilian companies at 16 percent. The two are so close that it’s quite possible that Brazil could become the most heavily weighted emerging market country in coming months or years.

How’s that? Well, VWO is designed to mimic the general composition and performance of the MSCI Emerging Markets Index, a collection of about 800 large cap stocks from 20+ countries around the world. (You can’t invest directly in the index, so instead you buy a fund based on it, such as VWO from Vanguard or EEM from iShares.) Weightings in this index are based on relative market capitalizations, not on country GDP. The bigger the company, the greater its presence in the fund.

Brazil is home to some massive, thriving companies. In fact the two largest holdings in VWO as of year-end 2010– oil company Petrobras and mining company Vale – are Brazilian. If Brazilian companies grow faster than Chinese firms, the land of legendary beaches and Carnival may take over the number one spot in the fund.

The heft of the Brazilian market may be a surprise to many. However, the beauty of indexing is that one need not predict the performance of different companies or countries in order to participate in their results. It’s simple Darwinian survival of the fittest – companies that grow in relative market capitalization become a greater percentage of the index fund. Current owners of VWO shares didn’t have to predict the fortunes of Brazilian companies to be part of their rise. By owning the index, they owned these and other successful companies as they grew. Meanwhile, struggling companies with falling market caps have become a smaller part of the index, or have been replaced by growing companies.

We can only guess what Charles Darwin might think about indexing. It seems likely that he would be a confirmed advocate. After all, it’s natural selection in the wilderness of wealth.


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