Concentration Through a Country Lens: Impact on Regional Diversification

Just as country indexes can become concentrated in a handful of stocks, the same can happen with regions. The first chart below shows the increased dominance of the U.S. in the MSCI World Index and China in the MSCI Emerging Markets (EM) Index. The increased concentration reflects the growth of the underlying constituents and countries.

To assess the impact on diversification in these regional indexes, investors can also look at the effective number of countries, which shows how many countries are “effectively” driving risk and performance versus the total number of countries in an index. The bigger the difference between the effective number and the number of countries, the more concentrated the index.

The second chart shows this in stark relief. At first, including China and others increased diversification, raising both the total and effective number of countries in the MSCI EM Index. More recently, however, the increased weight of China in the index reduced the effective number. Country concentration in the MSCI World Index, though quite high, has remained fairly stable until the recent uptick in the U.S.’s weight. Despite the increase in concentration in EM, the MSCI EM Index has been, and still is, less concentrated than MSCI World.

Active investors under-exposed to the U.S. or China may find it harder to outperform if the countries continue to do well, while an underweight may help if performance falters. Either way: concentration matters. Also, the performance of regional indexed portfolios will be increasingly driven by the two countries if their weights increase, potentially reducing the benefits of regional diversification.