Is Your Emerging Markets ETF Still a Diversifier?

Emerging markets are supposed to give your portfolio something different.

You buy an emerging markets ETF and imagine you are getting exposure to economies that do not move in lockstep with the U.S. market: Indian consumers, Chinese internet platforms, Brazilian banks, Saudi energy, Taiwanese technology, and countries most investors rarely think about.

However, many broad emerging markets ETFs are more concentrated than investors realize. A fund can own hundreds or even thousands of stocks and still have its returns driven by a narrow group of countries and companies. What matters is not the number of holdings. It is where the money is actually invested.

Emerging markets are more concentrated than they look

“Emerging markets” sounds broad. In reality, many EM ETFs today are heavily influenced by a handful of countries and companies. That does not make EM ETFs bad, but the diversification story is not as simple as the label suggests.

Look at the top holdings of a broad EM ETF and the same names often appear.

Taiwan Semiconductor, Samsung, SK Hynix, Tencent, Alibaba, Reliance, and large Chinese or Indian financial companies. Many of those companies are tied to the global technology and semiconductor supply chain. Taiwan Semiconductor, Samsung, and SK Hynix are all important players in AI-related demand. That means an EM ETF may have more exposure to the same technology themes already driving U.S. markets.

Adding an EM ETF can still diversify your geographic exposure. But if your portfolio already has significant technology exposure, it may not diversify your underlying return drivers as much as you expect.

==> See All Emerging Markets ETFs here

What to check before buying

Before adding an emerging markets ETF, focus on three areas.

1. Check the index methodology

Two emerging markets ETFs can look similar and still behave very differently because they may track different indexes.

Small index decisions can have a big impact on what you actually own. For example, MSCI Emerging Markets Index includes South Korea in its emerging markets indexes, while FTSE Emerging Markets Index does not. That single difference adds or removes major technology companies such as Samsung and SK Hynix, which can materially change the portfolio’s country and sector exposure. MSCI Emerging Markets IMI Index includes smaller EM companies, but since the index is still weighted by market cap the additional diversification benefit is limited. MSCI Emerging Markets Index Ex China is even more weighted towards TSMC, SK Hynix, and Samsung due to the exclusion of Chinese big cap names in the index.

2. Check the composition

Start with the top holdings. If a handful of companies account for a large share of the fund, the ETF may be more concentrated than the holdings count suggests.

Next, look at the country weights. Many broad EM ETFs are dominated by Taiwan, China, India, and South Korea. If you think you are getting balanced exposure across the developing world, the country weights may tell a different story.

Then check the sector exposure. Technology and financials often make up a significant portion of broad EM indexes. If you already have substantial exposure to U.S. technology stocks or growth-oriented equity funds, an EM ETF may provide less diversification than expected.

3. Check the ETF structure

Finally, consider the fund structure and tax implications.

Some Canadian-listed emerging markets ETFs hold a U.S.-listed ETF, which then holds the underlying international stocks. That extra layer can create additional foreign withholding tax drag.

The impact also depends on the account type. Foreign withholding taxes generally cannot be recovered in a TFSA, while some may be eligible for a foreign tax credit in a non-registered account. RRSPs receive favourable treatment for certain U.S. withholding taxes, but that benefit often does not extend to taxes imposed by other countries inside an emerging markets portfolio.

These differences are usually not large enough to drive the investment decision on their own, but they are worth understanding when comparing similar ETFs. Tax implications are available via DecodeETF's Real Yield Report Card.

The bottom line

Emerging markets ETFs can still play an important role in a diversified portfolio.

The point is not that they lack diversification. Compared with a single-country fund or a sector ETF, most broad EM funds are still diversified. The issue is that they may be less diversified than investors assume.

That is exactly the kind of question we help investors answer at DecodeETF. We break down ETF holdings, country exposure, sector concentration, and hidden risks so you can understand what you own before you invest.