In search of real diversification

Diversification is one of the investment world’s most important concepts. Its basic premise is that a portfolio consisting of multiple asset types is likely to perform better than one consisting of relatively few.

The idea first emerged almost three quarters of a century ago, when Harry Markowitz published his groundbreaking Modern Portfolio Theory. Further research has reinforced its relevance ever since, as has a wealth of real-world experience.

Even today, though, diversification’s full potential frequently goes unrealised. How some investors approach emerging markets (EMs) serves as a classic illustration.

Imagine, for instance, investing in EMs via the MSCI Emerging Markets Index. Comprised of more than 1,200 companies drawn from 24 countries, this offers what might be described as “broad” exposure.

The chance to access shares in hundreds of businesses in dozens of nations certainly sounds impressive. Yet it is interesting to reflect on some of the dimensions along which diversification is not so apparent.

When diversification is only skin-deep

Perhaps most obviously, the index is “top-heavy”. Four economies – China, Taiwan, India and South Korea – dominate . This significantly reduces the degree of diversification at a stroke.

In addition, there is no trace of smaller companies. Only large-cap and mid-cap businesses feature, despite small-caps’ proven ability to outperform their more sizeable counterparts over time.

An essential lesson here, then, is that diversification is often only skin-deep. Contrary to initial appearances, it may barely scratch the service of what is possible in terms of diversifying within an asset class.

It is right to stress at this point that the MSCI Emerging Markets Index serves many investors perfectly well. So do other indices that have attributes similar to those highlighted above.

Nonetheless, as active managers, we feel the scope for diversification in EM equities is greater than many investors appreciate. The key lies in moving beyond the bigger picture, adopting a more granular view and digging deeper.

Identifying hidden gems

Since abrdn Asia Focus does not have to track the performance of an index, we have the freedom to seek out opportunities that most investors are likely to overlook. As a result, we have substantial exposure to EM smaller companies.

Crucially, we aim to identify the most promising of these businesses by conducting our own in-depth research. This includes face-to-face engagement, which helps us assess policies, practices and prospects at first hand.

One reason why this is vital is that the analysts who work for major investment banks, fund brokers and other research-intensive organisations tend to pay these stocks little heed. They generally prefer to focus on large-caps and mid-caps.

Unearthing hidden gems has therefore become a job for specialists who can draw on their own “on the ground” knowledge. We believe this serves as an extremely powerful source of diversification.

The insights we generate enable us to spot EM smaller companies with a capacity for long-term growth. Many of these businesses are notably innovative, forward-looking and capable of supporting – or even driving – positive, far-reaching disruption.

The value of a bottom-up approach

Of course, diversification has its limits. Effectiveness seldom stems from sheer numbers, as might be demonstrated by exploring how many of the 1,200-plus companies in the MSCI Emerging Markets Index possess genuine appeal from an investment perspective.

We normally hold around 50 to 60 stocks in abrdn Asia Focus. These represent high conviction “best ideas” that are sensibly diversified across countries, sectors, industries and market capitalisations, as well as factors such as demographics, regulation and politics.

The bigger picture does play a part in our investment decisions. National and regional events, along with geopolitics and geo-economics, inevitably help shape our thinking.

But it is micro-developments at a company level that really count for us. Remaining invested in high-quality stocks – as opposed to, say, attempting to second-guess who might win an election or whether inflation will go up or down – is our guiding principle.

In our view, diligent stock-picking and active management are absolutely central to realising diversification’s full potential. In other words, real diversification comes from the bottom up – not from the top down.

Gabriel Sacks is investment manager, abrdn Asia Focus plc.

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