In contrast to the quote above, Mr. Buffett has been oft cited saying that average investors should passively manage their assets via index funds. What happens, though, when investors think that they are taking the latter advice, but their portfolio is indeed more concentrated than they assume? It does not happen frequently, but over the past several decades, some prominent indexes have occasionally exhibited less diversification than a casual observer would expect. This history lesson is timely now because Chinese stocks are closing in on a 30% weighting in the MSCI Emerging Markets Index and come June will be almost 40% of that benchmark.

The examples below are not an exhaustive history of periods of high index concentration and may not describe the future of the Chinese stock market, but we believe that they provide some perspective to consider.
 

• At the end of 1988, Japan’s weighting in the MSCI EAFE maxed out at almost 65%. As the chart below shows, the country’s return in the index for the prior decade was over 26% per year. Japanese stocks contributed most of the EAFE’s outperformance relative to the S&P 500. For the following decade through December 31, 1998, Japan’s country return in the EAFE was less than -5% per year which vastly underperformed other international markets.

 

• Domestically, we experienced a similar phenomenon when the “Tech Bubble” in the early 2000s resulted in the Information Technology sector of the S&P 500 becoming almost 34% of the benchmark[1]. For the five years ending March 31, 2000, this sector had a total return of over 50%, far outstripping the second best performing sector[2]. Like the example above, the period following these strong returns failed to reproduce outsized returns relative to the overall market. From April 1, 2000 through March 31, 2005, technology stocks dropped 18%, underperforming the broader market which registered a -3% return. Technology has provided wind to the sail of the recent bull market; however, as of March 31, 2018, it stood at 25% of this benchmark.

Some characteristics of the recent Chinese markets runup are similar to those outlined above[3]; however, investors could make an argument that there are also significant differences. To us, the most important fact is that investors should understand what they own, especially when their “diversified” portfolio begins to look more like the Oracle of Omaha’s investment account.
 

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[1] The Information Technology sector, as defined by Standard & Poor’s, was 33.6% of the S&P 500 as of March 31, 2000.
[2] The Financial Sector, which was the next best performing sector, returned 26.5% over the same period.
[3] For the decade ending 03/31/2018, the MSCI China Index has gained 6% per year whereas the MSCI Emerging Markets Index has earned 3% per year.

Sources: Standard & Poor’s and MSCI

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