Hello! And welcome back to The Institutional Beat podcast, where we cover interesting and relevant topics for institutional investors. My name is Julie Ducharme, and I'm an institutional portfolio manager on the PH&N Institutional team. And I'm delighted to be back hosting today's episode. So today we're exploring a phenomenon that's going to feel eerily familiar to Canadian institutional investors and to all Canadian investors, because we're talking about extreme index concentration driven by a single transformative technology.

And many of us veterans will remember when Nortel Networks peaked at over 35% of the TSX index here in Canada, and that was in the year 2000. And it dominated our Canadian market during the telecom and the internet boom. And it was great while it was going up, but unfortunately, Nortel created this concentration risk that we'd never seen before.

And unfortunately, we all know how that movie ended. And it was devastating when the tech bubble burst, and then you had this concentration that became so extreme that it actually prompted reaction by index providers. And on May 20^th, 2002, S&P launched the S&P TSX Composite Index as we know it today, which limits any single security to a maximum rate of 10%.

And this actually matches what we as investors need to respect as well. So this capped version was created specifically to address the concentration risk that had become problematic for Canadian investors, to try to keep that diversification that everyone needs so dearly. And so the creation of this index was really a direct response to the lessons we learned from Nortel.

And today it's the default index for most Canadian institutional investors. And funny enough, we haven't needed it since. But if you fast forward to today, we're witnessing a strikingly similar situation in a few global markets. But this time, what we're talking about today is what's happening in emerging market indices. As of this week, Taiwan Semiconductor Manufacturing Company, or TSMC, is hovering around 15% of the MSCI Emerging Markets Index.

And we have two countries, Taiwan and South Korea, combined that account to close for half of the benchmark. Now, the parallels to our Nortel experience are unmistakable. Well, at least in my opinion. And it raises important questions about concentration risk, both about the market dynamics that we're seeing and just portfolio management in this AI-driven world. And it's really the first for the emerging market investor, because we're seeing this extreme single stock and single theme concentration.

And we've experienced it firsthand in Canada, but believe it or not, that was over two decades ago. So I'm personally wondering: are there lessons from our Nortel experience that could be helpful to navigate this AI-driven concentration in emerging markets? Maybe we'll need a new index. We'll see. But to unpack this issue, we're bringing in the big guns, and it's my pleasure to introduce our guest today, Dijana Jelic, senior institutional portfolio manager on the RBC Emerging Markets Equity team.

She's based in London, UK. Dijana, welcome to the show.

Great. Thanks for having me, Julie. Really great to be here.

Great. Well, Dijana, although you're not based in Canada, I suspect that the parallel to Nortel isn't lost on you. You maybe didn't live through it firsthand, but certainly there's a lot of parallels I think you can connect with. And what I like about your team's recent paper, which we'll have a link to in the description of today's podcast, you highlight the seismic shift in emerging market indices, right? We've got Taiwan, South Korea now dominating in ways we haven't seen before. And so for our Canadian audience, or maybe those who aren't as familiar, could you walk us through what this transformation looks like and just help us understand what the current situation is in emerging markets?

Yeah, no, absolutely, Julie. I mean, you mentioned some of the striking stats there. But just to give a bit more context: so, I mean, today we've got Taiwan and Korea. They're representing about 50% of the benchmark, say Taiwan's weight – depending on the day, given it's very volatile at the moment, but depending on the day, Taiwan's around 28% weight.

Korea's between 22 to 25%. And then you've got markets like China that only 5 or 6 years ago were actually over 40% weight of the benchmark. I mean, that weight’s now halved to 20%, and India is now only 10 to 11% versus about 20% in in 2024. So not that long ago. So in the space of a couple of years, we've really seen some dramatic country shifts in the MSCI Emerging Market Index, something we've really never seen before.

Okay. So what's going on underlying that's causing this. We know Taiwan and South Korea are massive beneficiaries or sources of the global AI infrastructure buildout. Can you give our listeners some highlights on some of these key shifts and why it's coming from those places?

Okay, alright. So I mean, it's all AI-driven. So I think what's really happened is that investors globally have woken up to the fact that Taiwan and Korea have really become critical to the AI value chain. You have some really globally critical, companies – so the likes of TSMC, Samsung Electronics, and SK Hynix – that have become leaders in semiconductors, and their technology is really unparalleled in the high end, so really memory, particularly with Hynix, and then TSMC on the foundry side. So if you look at these companies’ revenues, their margins, their market value, its grown dramatically over the past five years. So whilst we've seen all of the AI capex coming really from the U.S. with the hyperscalers, I think what investors are increasingly recognizing is that the beneficiaries of that capex and are largely in emerging markets, so predominantly the companies I mentioned, but there's really a huge value chain with many other companies as well. But what that means from an index perspective is that we've already seen the share price of particularly TSMC, Samsung, and Hynix, and all of the AI-related stocks do extremely well. But that's also led to this precedented index concentration.

So TSMC weight in the index is over 15% currently. You've got Samsung, which is between 7 to 10% depending on the day. And Hynix is now nearly 7%. And that compares to less than 1% only five years ago. So again, we've seen drastic shifts at stock level. So if you take the top five constituents in terms of stocks in the index, we're now at a weight of about 35%, which again, is an unprecedented level.

Now, have we seen this kind of concentration in the past? And maybe shed some light on how that affects your portfolio construction because as fundholders we’re limited to a max of 10%. But what does it mean when you're trying to diversify your investments and build out a portfolio that's a little more all-weather?

Yeah, so  to give some historic context, if you look at the weight of the top five, constituents only 20 years ago, it was about 13, 14%. So that 35% is very extreme and really unprecedented in the benchmark. When we look at the history of MSCI EM, what that means is if you look at performance, it's become extremely narrow.

So if we look over the last 12 months, less than 25% of stocks have actually outperformed the benchmark. And also if you look at performance by country and sector level – by sectors, we've only got IT that’s actually outperformed in emerging markets. So as of the end of June, the index is up about 24% and in U.S. dollar terms it's up over 92%.

You've got other sectors like Consumer Discretionary that's down 20%, Communication Services down 18%, Consumer Staples down 6%. So really huge bifurcation in terms of performance at sector level. And similarly, at country level, Korea and Taiwan are actually the only two markets that have outperformed the benchmark over the last 12 months. You've got the likes of India, China, Indonesia, South Africa that have all been in negative territory. So it's a very narrow performance up until the end of June.

This is such a big shift for India, which was the market darling for such a long time coming into this run up in AI. So what are the seismic shifts that we're also seeing? Is that the rebirth of emerging markets after the announcement of the tariffs – the kind of the whole world realized that, wow, emerging markets don't really have that much trade with domestic markets.

So if you want to participate in this global growth, you really need to start investing in directly into emerging markets. And so you have this huge uptick in demand. And now the tailwind really is for emerging markets. And we saw that in the performance of emerging markets last year just crushing developed markets. It's attracting passive investors, right? And this is going to only amplify these moves. When you have single-stock concentration, you have more people buying the index, more people driving them up. So can you talk a little bit about this feedback loop that's coming into emerging markets? Is this a newer thing? Is it reinforcing the problem? And maybe I'll make a sidebar that this isn't actually a new phenomenon. We're seeing it in the U.S. equity market right now, but it certainly feels a lot newer for emerging markets.

Yes. You're right. So I think really since COVID, we've seen the rise of retail investors globally and I think also accelerated by technology - so smartphones, trading apps – everybody seems to be an investor these days. And it's definitely something which has been challenging as active, fundamentally-driven, fund managers trying to navigate these more speculative, volatile markets, particularly, in the last couple of months, really driven by AI speculation.  It has definitely been challenging.

And I'd say really a key reason why we've seen this increased index concentration. Because ultimately, as you said, it's a feedback loop for hours. Essentially, as stocks outperform, their benchmark weight increases. And then that attracts additional passive flows and then further increases, the weight of those constituents. So definitely something which is exacerbating the current concentration limits.

And also, I'd say, some markets like South Korea in particular, where we've seen this extreme retail euphoria, I'd say, is presenting short term risk. And even the Korean regulator literally came out overnight expressing considerable concern around some of this retail speculation, particularly in the context of essentially leveraged single-stock ETFs.

So it looks like some regulation will come out around that to curb this speculation and all of this retail money that's this really being pumped into a very small number of AI-related stocks. So something which we're really monitoring and really trying to navigate, whilst at the same time, trying to also look through the noise and focus on long-term fundamentals, which is really what our strength is.

Yeah, because leverage is something you seek when things are going well. But given the volatility of some of these names, and if it turns, could be leaving people really sharply behind.

Yeah, absolutely. And actually in the last few weeks, as I mentioned, in Korea we've started to see some really big moves and considerable correction. So, when that unwinds, that can be quite damaging.

Yeah, because the retail investor might not appreciate what they were signing up for. And actually, I think this is a nice way to pivot because I don't want to be all doom and gloom about the single stock concentration. There's a reason why these companies have gotten so big. And in your paper, what I like is that you balance –  yes, this concentration issue, but also the potential for meaningful earnings growth and just, frankly, the genuine technological leadership that we have in these companies, right? And I'm sure this is a great source of debate within your team, right? And so I'd love to get a look into how you balance out this argument for these fundamentally strong investment opportunities, these great companies.

But then you've got to manage concentration risk of in your portfolios. Is this a constructive debate? Is it kind of a source of heated discussion? Because I imagine it's easy to get caught up in the euphoria and get carried away.

Yeah, you're right. Every day we're having a lot of definitely heated, passionate discussions on this topic. And, yeah, I'd say definitely from a short-term perspective, we do feel what's happening in terms of the extreme market moves, the concentration question marks around the huge capex that we're seeing, and AI monetization and the fact that a lot of this capex is being fuelled by debt – these are some of the aspects that we think are in question.

I think the issue is when we've seen these extreme environments, it’s clear that they rarely persist. But trying to predict the path of that adjustment is really very difficult. So I think the difference maybe this time round to other potential bubbles is that, as you said, there are very strong fundamentals.

So we continue to see very strong earnings growth from these companies. They do exhibit genuine technology technological leadership. So we have owned a lot of these names for many, many years, and we continue to have very high conviction. And we do feel that AI is a very powerful, multi-decade theme.

And there will be clearly some significant winners. But also, some of these – in terms of how we're thinking about AI currently, we're really trying not to be too extreme one way or another, but really to focus on our stock selection. So if you look at our performance and our alpha generation, the vast majority comes from stock selection.

And that also continues to be the case in this extreme environment. And that's really what we're trying to achieve. I think given what's going on, we're really trying to focus on valuation and to avoid valuation extremes. And ultimately, we're being very active. So we are trimming on extreme moves. We're recycling some of these proceeds into other AI names that are potentially less discovered or more attractively valued, but also, I guess at the margin side, starting to recycle into some non-AI areas that have really been left behind in this market environment. And I think longer term, one of our key themes in our portfolio is technology transformation. And AI continues to be a key way to play. So we are positive longer term. But in the shorter term, really the focus is on trying to navigate this extreme market environment, which in our view is unlikely to persist.

And you talked about other AI names and then non-AI areas. I'm going to come back to those. But I want to first get your thoughts about, like, do you think this concentration is going to persist? Or, like many things, would it eventually subside over what time horizon? I'd be curious. Do you have any thoughts there, or experiences from the past that you've learned from?

Yeah, I mean, it's always market timing. It’s always, very tricky. So it's something that we as a team try to avoid doing. I mean, it's basically impossible to do. And you can really get burned if you get it wrong. So, as I mentioned, we really focus on the stock selection and try to be neutral when it comes to these extremes – in this case, in terms of our AI exposure.

I think when we look back at history, the current environment does remind us of what we saw around COVID. So 5 or 6 years ago, where it was the last time we had a similar kind of growth bubble. So at that time, it was actually largely Chinese tech companies that were doing very well. That was the time when actually China's way peak to 43% of the benchmark.

I guess it was a little bit different. A lot of these tech names were actually profitless, so the fundamentals weren't there. But again, when we looked at the market mix, we looked at some aspects of concentration as well. We felt that markets had moved ahead of themselves. And at that time, we actually refused to follow the market.

So, whilst we did have good exposure to China in our portfolio, it was significantly lower. We didn't chase that 43% – the weight that it became in the benchmark. So clearly, whilst that bubble was occurring, we weren't benefitting on the upside. But then when that bubble burst in 2022, that's really when it paid off, when we generated a lot of alpha, really protecting in that down market environment. So that's really how we tried to navigate the extremes.

Okay, I want to come back. You talked about other AI names. Let's move away from those top three that we keep focusing on. But your paper talks about expanding opportunities set. You talk about attractive opportunities, whether it's in semiconductor design, ASIC development - ASIC stands for Application-Specific Circuit development. We got power infrastructure cooling tech –  super interesting, testing equipment, networking, and just industrial automation. Are these second and third-order companies and beneficiaries? Are they interesting investment opportunities that we should be looking at?

Yeah, no, absolutely. I mean, I think Guido – he's our Taiwan tech specialist on the team.

And we had Guido on for a podcast a little while ago.

Yeah, he’s got a great chart where it really shows that if you look at the five names that are 35% of the benchmark, but then if you look at the number of stocks in emerging markets that are exposed to those AI areas that you mentioned, we're talking more like 100, 150 names dominated by Taiwan and Korea, but there's a lot of interesting names in the AI value chain really located in emerging markets.

So, in our portfolio and as part of our thematic approach, we have over the last five years been focused on AI enablers – so those companies that are benefitting from the capex, buildout, the infrastructure buildout. And we do still feel that those companies are well positioned and that story will continue.

But ultimately, when we look ahead and we think about the next phase of beneficiaries, we do also think that those companies that are able to successfully deploy and actually monetize AI applications will be the next winners as well. So we do have some capex exposure in the portfolio already. But I think being selective will really be key.

I mean, there's going to be some areas that will become commoditized as more competition comes in, given the very high earnings and the high growth. Natural progression is to see competition. So really focusing on companies with genuine tech leadership, strong competitive moats, and being very selective in terms of the AI application side, focusing on those companies are likely to successfully be able to monetize.

So yeah, being selective in this area will be key for us. But there definitely are a lot of interesting opportunities. And we are hopeful that those opportunities will be reflected in the index, because obviously currently it's very much concentrated on a very small number of stocks.

Yeah, but it's nice to know that there's some interesting investment opportunities out there for us as portfolio owners. I want to come back to also the non-AI areas that you've quickly mentioned, and maybe this is for completeness, maybe to encourage our listeners to think about diversification and maybe pay justice to the other thousand companies in the emerging market index.

But maybe just give us a sense of what other quality stocks, other domestic sectors – like we mentioned how tough it's been for consumers, financials as well. These have been out of favour. Some of them look really cheap right now. What's the team's latest thinking on these? Is this a good time to be considering them, and how do they fit in?

Yeah, I mean, that's a great point. Right now, now even though EM delivered strong performance and we have some areas in market that have done extremely well, there's still a lot of opportunities. We think there's still a lot of alpha on the table in many different areas that have been completely left behind. And definitely, I'd say the domestic areas – areas that we tend to gravitate more towards given our top-down thematic approach.

So areas like Consumer and Financials. I mean, if you look at the valuation of these areas now relative to Tech, they've really never been so cheap. I mean, Consumer Staples has always traded at a premium, and that premium has now completely eroded. Financials are trading at the widest-ever discount to Tech. So these areas – I mean, if you look at their fundamentals, their returns are still very strong.

But the valuation is now very compelling. And similarly, when you look at countries, there's still a lot of good stories outside of AI and EM that have been completely ignored. So if you look at whether it's LatAm, whether even India now is looking – which has always been very expensive on a relative basis – it's now more compelling from a valuation standpoint.

China - we definitely think, whilst there are challenges for the country, we still think there's a lot of really strong companies there. And they're actually building out their own AI ecosystem and doing pretty well there. So there's a lot of interesting stories and valuations across these areas outside of AI currently do look very compelling.

So I guess the main challenges is we don't know how long this AI euphoria will continue. But definitely we are starting to recycle some of the proceeds into these non-AI areas where fundamentals in the outlook still look very strong.

Great. Well, maybe I'll ask you one final question. And maybe taking ourselves at a big picture level, let's look out over a longer horizon, maybe over the medium term. I know your team, and frankly, so do I, believe that the emerging markets are going to continue to outperform developed markets. It was 12 years where we saw nothing but being a laggard.

Time to shine. Any nuggets that you want to share to support this and maybe entice our listeners to either consider this space, learn more about it, or just appreciate maybe why not to be so reticent about considering emerging markets.

Yeah, so I mean, we've been calling for a positive cycle in emerging markets perhaps a bit too early. But what we started to see actually is, obviously, as you mentioned, we had a very tough few years. So over a decade of underperformance against developed markets, particularly the U.S. So it was really all about the U.S.

But really since December 2024, that has started to turn. So I was actually just looking today – EM is up over 63% since December 2024. And that's basically double the U.S. market, nearly double developed market. So we've seen really strong outperformance of the last two years. And our feeling is that it can continue.

So what we found when you look at a long-term period, the relative performance of EM and DM equities moves in long cycles. And there's a couple of factors that really drive these cycles. So I'd say probably the most important one is earnings growth. And you mentioned that 12-year period of underperformance. And when EM has underperformed, typically we haven't seen any earnings growth, and especially in that time, the U.S. delivered very strong earnings. What we started to see since December 2024 is that story turning, where earnings growth now is really picking up in emerging markets. It's actually outpacing developed markets. And that's expected to continue for the next couple of years.

And I think what's also really interesting is, clearly a lot of that has come from South Korea and Taiwan and the AI story. But it's also starting to broaden out. So if you look at upgrades across the rest of emerging markets outside of Taiwan and Korea, these are also starting to pick up.

So that gives us some confidence. And it's something we'll be really watching carefully because we really do need these earnings to come through for that next leg of outperformance for emerging markets. But I think if also if we take a longer-term view, we also think that emerging markets have really transformed over the last decade or so.

If you look at the fundamentals, they've really shored up the fundamentals. I think governments have really learned the lessons from the past. They become a lot more orthodox, a lot more restrained in terms of fiscal spending and debt levels. All of these fundamentals have improved, particularly relative to the U.S., and they become a lot more independent.

So what we're seeing now, especially with this geopolitical environment, is that EMs are increasingly cooperating and trading amongst themselves and reducing their dependance from the developed world. So if we take more of a ten-year view, and if we’re looking back and if we were right that EM can outperform over the next decade, we feel the main theme will be one of EM basically becoming increasingly independent and learning to fly on its own.

Such a great way to close it out. We have the benefit that this AI boom has really shone a spotlight on the emerging markets and their importance in the global ecosystem. But it's also revealing that you have these fundamentally very strong companies in emerging markets. We touched on the fact that there are probably some great entry points on valuation right now across the different markets if you're prepared to be a little contrarian, or that's why you hire a professional to do it for you. And that, frankly, emerging markets don't really need developed markets to thrive anymore. So if you want to participate in this growth over the long term as an investor, as you say, maybe it's time to fly with the emerging markets and not just as a small little some component in your global ACWI IMI allocation.

So I hopefully it's good food for thought for investors. I loved everything that you were able to share today. Took away a few interesting points myself. Thank you so much, Dijana, for joining us. And also thank you to our listeners out there. If you enjoyed this episode, please follow us on future episodes. We have some great topics lined up in the months ahead, and we hope you can join us again next time.

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