During the last quarter of 2008, the Harvard University Endowment quietly overhauled its public equity investment portfolio. By the end of the overhaul, the top 10 positions in the portfolio looked like this:

Chart credit: Paul Kedrosky

Most strikingly, seven out of the top 10 are emerging-market exchange trading funds (ETFs), with emerging-market index fund EEM and China index fund FXI the largest and second largest holdings, respectively. Year to date, EEM is up 24.55%, and FXI is up 20.85%. Comparatively, the S&P 500 is flat.

Harvard’s public equity portfolio overhaul was made public in its 13G filing with the Securities and Exchange Commission on Feb. 13, 2009. I took note immediately and wrote about it in my blog.

Historically, emerging markets are very dependent on the U.S. economy. There is a saying: “When the U.S. sneezes, the world catches a cold and the emerging markets get pneumonia.” Now, with the U.S. catching pneumonia itself, it was a very brave move on the part of Harvard to invest in emerging markets.

Harvard must have done its homework, though. The current crisis was to a great extent caused by high finance that turned junk bonds to triple-A bonds. The emerging markets haven’t quite mastered this “technology;” their antiquated banking systems turned out to be a blessing in disguise.

Much of the emerging world hasn’t acquired the U.S. taste for living beyond its means; China, for example, has a saving rate of over 40%. This allows the Chinese government to quickly implement a stimulus package almost the size of the U.S. package and a negative sales tax (-17% for rural residents) to unleash these savings.

What does all this mean for individual investors?

First, emerging markets are no longer an insignificant part of the world economy. Merely allocating 5% of your portfolio to emerging markets, as recommended by most advisors, is not doing yourself or emerging markets justice.

Second, being the largest economy in the emerging world, China’s economic policies reverberate well beyond its borders. To grow your portfolio, it’s not enough to watch the U.S. (and other developed countries), you also need to watch China (and other emerging markets). Case in point, the Taiwan index fund is up 47% year to date; much of that gain was caused by China’s policy change.

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