Diversification · Asset Allocation · Investor Behaviour
When a Diversifier Stops Diversifying
A basket held for its difference from the crowd can end up owning the crowd, because the label is fixed and the contents are not.
A thali arrives with a spread of small bowls. You order it for the variety. If the kitchen has filled most of them with the same dal, the plate still looks like a thali from across the room. The label outlives the contents.
Baskets of shares behave the same way. Most of them weight their holdings by market value, so when one theme runs hot, the companies attached to it grow larger inside the basket without anyone deciding to buy more of them. Weight accrues to whatever has already risen. The name on the basket was fixed the day it was written. The contents move every day.
When the label stops describing the basket
Emerging market equity is the working example. Global investors held it for years as a counterweight to the largest developed market, on the reasoning that different economies, different currencies and different growth drivers would not all move together. The reasoning was sound when it was formed.
The composition then changed underneath it. Two markets now account for close to half of that basket by weight, and its five largest companies account for over a third. The companies whose revenue is linked to artificial intelligence sit in a small number of places.
| Market | Share of the market by weight with revenue linked to AI |
|---|---|
| Taiwan | Around 80% |
| Korea | Around 50% |
| Emerging markets overall | Roughly 30% |
| India | Negligible |
So the correlation inverted. A basket bought as a diversifier away from the largest developed market now moves with it more closely than other developed markets do, because a single theme drives both. An investor holding both, expecting them to behave differently, holds one exposure written down twice.
Correlation lives in the contents, not in the label, and the contents are decided by whatever went up last.
Read the earnings, not the label
The test that survives this is a question about earnings. What has to go right for the profits behind this holding to arrive? Ask it of every large position. Where two answers are the same sentence, there is one position, whatever the two labels say.
India sits on the other side of that test today. Its listed earnings come mainly from domestic demand spread across a wide range of sectors, with almost no direct link to the global capital spending cycle behind the current theme. Its sensitivity to American interest rates is also lower than that of the markets now leading the basket. Those are descriptions of what drives profits, not forecasts of what any share will do.
Leadership inside emerging markets has rotated repeatedly over the past twenty years, and the top two positions have changed hands several times. Rotation of that kind is ordinary. What matters is that concentration builds without instruction, so anything held for its breadth has to be checked against the reason it was bought.
Diversification is a claim about contents. It has to be re-examined whenever the contents move, which is always.