As political turmoil> in Egypt roiled stock markets last week, a thought crossed my mind: Do I own any Egyptian stocks?
Surely not. I couldn't even say for sure that Egypt had a stock market until I read that trading had been halted. Although the market swooned last Friday, I wasn't unduly worried about U.S. stocks. After eight straight weeks of gains it was undoubtedly due for at least a minor correction, and Egypt offered an excuse to sell.
Still, the recent fall of Tunisia's long-standing president and the revolution in Egypt are a reminder that among the many risks that stock investors assume is that of political change, especially in less durable emerging market governments. The stability of the American democracy and political system is a reason U.S. stocks have historically commanded higher price/earnings ratios and why many investors (including me) allocate a larger share of their portfolios to the U.S. market.
The Egyptian stock market was hard hit in the wake of the crisis, plunging 16% last week before it was closed on Friday; it's expected to resume trading on Feb. 7. Contrary to my initial assumption, when I lifted the lid on some of my exchange-traded funds, I discovered that I did in fact own Egyptian stocks. Thanks to the global diversification offered by numerous mutual funds and exchange-traded funds, Egyptian stocks are represented in funds that model their portfolios in whole or in part on the MSCI Emerging Markets Index, which in my case includes the iShares Emerging Markets Index Fund (EEM)
The MSCI Emerging Markets Index consists of 21 countries, including Egypt. Shares in the EEM index fund dropped on the Egypt news, and year-to-date are down a little over 2%. Nearly all of the emerging market index countries are to varying degrees stable functioning democracies, including India, Brazil and South Korea. China is the glaring exception, but not since Tiananmen Square has anyone seriously questioned the stability of the ruling regime. There has been some recent political unrest in Thailand and Malaysia, which are both relatively small components in the index. Egypt also makes up a very small part; it represents just 0.6% of the MSCI Emerging Markets Index. In my view, fears of contagion, so far as it would affect emerging market stocks, are overblown.
Egypt shows up more prominently in the few so-called "frontier market" funds, even though it's not a part of the MSCI Frontier Markets Index, which consists of 28 countries, many of them with authoritarian governments. Among them are Bahrain, Jordan, Kazakhstan, Kuwait, Oman and Qatar. The Guggenheim Frontier Markets ETF is based on the Bank of New York Mellon New Frontier DR Index, which includes Egypt. Egypt represented 13% of the portfolio at the end of 2010, but the only other authoritarian regime in the top ten countries in the ETF was Kazakhstan (4.3%). (At 32%, Chile represents the largest share of the fund's assets.) Other so-called frontier funds tend to be misnomers; they're actually concentrated in specific geographic areas, such as the Middle East.
These funds are likely to be the most volatile in response to events in Egypt. There's even an Egypt-specific ETF, the Market Vectors Egypt Index Fund, managed by Van Eck Global. The fund had to suspend trading last week.
I believe the events in Egypt pose minimal risk to investors in broadly diversified international funds or emerging markets funds. Indeed, on further reflection I was glad that I did have some exposure to Egyptian stocks. The whole idea of indexing and diversification is to avoid trying to pick winners and losers. And the funds' low exposure to Egypt and other risky frontier markets strikes me as about right. I don't see any need for the frontier markets funds or country-specific funds given that investors can get exposure to these countries in much more diversified funds.
I also find it less than self-evident that the impending departure of Egyptian President Hosni Mubarak, an authoritarian dictator who has been throwing political rivals in jail for decades, will be bad for markets. There was immediate talk of dominoes falling across the Middle East and disruption to oil supplies. There's no way of knowing the future, but is any of this plausible? Investors never seem to like sudden, unexpected change, but I don't think the loss of another dictator is cause for undue concern, even if he was a staunch U.S. ally. Many have come and gone, and yet the march of global capitalism has continued apace. Even the replacement of the Shah with Iran's anti-American theocracy a worst-case scenario to which Egypt has been compared hasn't dampened global stock markets in the ensuing decades. I'm no expert on Egypt, but given Mubarak's track record, I'd say it's at least as plausible that a replacement will be good for Egypt's economy and for investors--not to mention Egypt's long-suppressed citizens.