I have been gradually increasing my emerging market equity allocation over the past six months, moving from 12% to 19% of the equity book. This goes against the consensus, which remains heavily tilted toward US equities after years of US outperformance. Here is the full thesis.
O Stock Valuation 2026: Is It Undervalued?
The MSCI Emerging Markets Index trades at approximately 12x forward earnings. The S&P 500 trades at roughly 21x forward earnings. This 9-point gap is near the widest it has been in twenty years. Mean reversion alone — without any change in underlying fundamentals — would imply significant EM outperformance over a 3–5 year horizon.
Book value tells a similar story. EM equities trade at 1.6x book on average, versus 4.2x for US equities. The US premium is partly justified by the dominance of capital-light technology businesses, but it is not justified at this magnitude when you look at sectors like financials, energy, and industrials, where the valuation gap is equally extreme.
Currency Risks
The primary counter-argument to EM equities for a USD-based investor is currency risk. When the dollar strengthens, EM assets decline in USD terms even if local prices hold. The 2021–2023 dollar rally wiped out significant local-currency gains for EM investors.
My view: the dollar is near the top of its range on a trade-weighted basis. The factors that drove the dollar rally — US rate differential and relative economic strength — are both peaking. If the Fed begins cutting in 2025 while EM central banks (many of whom raised rates more aggressively) hold steady, the rate differential narrows and EM currencies recover.
I am not hedging currency exposure at the portfolio level. The cost of hedging EM currencies is prohibitive (often 3–4% annualized for BRL, INR, or TRY), which eats the yield advantage. Instead, I focus on countries with current account surpluses and/or strong dollar-earning capacity — which reduces but does not eliminate currency risk.
My Picks
I am not betting on a single country — concentration in EM is dangerous given the idiosyncratic political and currency risks. My allocation is split across three vehicles:
VWO (Vanguard FTSE Emerging Markets ETF): 8% of the portfolio. Broad exposure, low cost (0.08% expense ratio), liquid. The largest weights are China, India, Taiwan, and Brazil. This is the core position.
EWI (India — iShares MSCI India ETF): 4% of portfolio. India is the structural growth story I am most confident in — demographics, digitization, manufacturing relocation from China. Valuation is less attractive than the broader EM basket (India trades at 20x forward), but the growth justifies a premium.
Direct stock positions in Brazil (Petrobras, Itaú Unibanco): 7% of portfolio. Brazil is deeply unloved and deeply cheap — Petrobras trades at 4x earnings and pays a double-digit dividend yield. The political risk is real but priced in.
Position Sizing
I am building this position slowly, adding 1–2% of the portfolio per quarter rather than moving all at once. The rationale: EM can stay cheap for a long time, and timing the turn is impossible. Averaging in over 6–9 months reduces the risk of catching the position just before a dollar spike or an EM-specific shock (elections, debt crises, commodity price moves).
The full target allocation is 22–25% of the equity book in EM. I am at 19% today. If the valuation gap narrows materially — say, EM re-rates to 16x forward — I will trim back to the 12–15% range. The thesis is valuation-driven, and I will exit when the valuation no longer supports the position.