Emerging Markets – Is the Juice Worth the Squeeze?
FWP is grounded in researching long-term data and testing it to see what investors need to implement to achieve long-term goals.
An investment in Emerging Market equities (EM), an idea that started to gain traction in the late 1990s, is now generally promoted as one of these “needed” allocations that will increase returns and reduce risk through diversification.
This piece lays out what we found when questioning this narrative.
Our Experiences – Circa 2010
A dozen years into our careers, emerging markets were hitting on all cylinders, their story strong, growing even during the 2008 crisis. EM stocks had averaged 22% returns each year for nearly a decade. We were smitten, full of energy, and with a logical argument favoring EM in hand, we championed its inclusion in portfolios.
What follows is what we experienced and learned since then through testing, with our conclusions at the bottom.
The Emerging Markets Story
One of the key factors driving enthusiasm for EM in the mid-2000s was their rapid economic growth. In 1994, emerging markets were estimated to be 18% of the global economy but by 2010 they had grown to over 35% of global GDP.
Unfortunately for investors, as studies have consistently shown, economic growth has not translated into strong stock market performance. As well respected EM researchers reminded readers in a recent peer reviewed Journal of Portfolio Management paper…
“Research has demonstrated that GDP growth is a flat-out unreliable predictor of country-level stock returns.”
Yes, as we were all taught in undergrad Finance 101, but sometimes forget, economic growth rates are not leading stock market indicators.
As we experienced during COVID in 2020, future stock market returns are often the highest when economic numbers are the worst.
The Empirical Evidence – EM Stocks Have Consistently Underperformed
Looking at long-term returns that span both good and bad economic cycles, the chart below compares the MSCI Emerging Markets Index from its inception in 1988 to US stocks.
Source: US (US) and Emerging Markets (EM) present the performance of the Russell 3000 index and the MSCI EM index respectively, as reported by Y-Charts and MSCI.
The 1.4% per year on average underperformance illustrated on the left may seem modest but as we show on the right, the compounded difference has been quite large.
An investor who put $1 million into an EM index investment in 1988 would have $13 million dollars less than an investor who simply kept the funds in the U.S. market.
EM Returns are Inconsistent and Volatile
Beyond this underperformance since inception, EM returns are largely driven by just two time periods – the 1988-1993 initial period when there were only 8 investable countries and then during China’s 2000s urbanization boom.
When these periods are removed, the following is how cumulative returns compare to U.S. returns. A U.S. only equity investor would have generated almost $9,000,000 in gains. On the other side, an investment in EM stocks would have lost approximately $200,000.
Source: US Stocks (US) and Emerging Markets Stocks (EM) present the performance of the Russell 3000 index and the MSCI EM index respectively, as reported by Y-Charts and MSCI.
Turning to the risk and consistency side of the equation, the case is not any stronger for EM.
Since the inception of the MSCI Emerging Market index (EM) in 1988, the historical volatility or standard deviation of returns of EM is double that of US stocks.
And looking at the probability of upside opportunities, U.S. stocks produce positive annual returns approximately 80% of the time. EM equities… only 50%.
Knowable Risks
Beyond the numbers above, which do change and can be time period dependent, it’s also good to be mindful of known knowns.
Geopolitical risk in emerging markets is much higher.
In the words of Paul Podosky, a former Bridgewater Research Director and expert in emerging markets geopolitics, he doesn’t hold any EM positions because…
“Emerging markets… [tend to] have weaker rule of law, and the risk of carrying those in your portfolio is significant. You need to apply a geopolitical filter on your choices in terms of investment and be pessimistic.”
As an example, a few years ago many suggested that the Russian market was significantly undervalued. Then, Russia invaded Ukraine.
The Active Management Argument Debunked
In writing this, we are already hearing the counter arguments, including one that may go like this…
“We admit that EM as a whole isn’t all it’s cracked up to be, but the inefficiencies in this market make it the perfect place to allocate to active managers that can identify attractive countries, sectors, and companies.”
This EM case seems sound, but when we question it by looking at the data, it doesn’t hold up.
According to Morningstar, EM index funds outperformed two-thirds of Morningstar’s emerging markets active peer group over the past ten years.
Looking out further, Dow Jones Standard & Poor’s also found that only 5% of EM active funds outperformed index alternatives over the past 20 years – a figure that isn’t much higher than the more publicized low success rates of U.S. active managers.
Small to Modest Allocations Don’t Move the Needle
Finally, in line with the quote below from a talk we had with Joachim Klement, previously the Head of Investment Strategy at UBS in Europe, even if you can find an outlier opportunity, the approximate 5-10% allocations we see to EM don’t make a large impact.
“Even if you knock the lights out and make an investment that outperforms by 5%, it doesn’t move the needle.”
“The math is that a 5% allocation to this exceptional manager only adds 0.25% of performance to the total portfolio.”
As we highlight above, however, EM allocations haven’t outperformed, they’ve generated lowered returns with greater risk.
Our Conclusion – It’s Not Worth It
As John Maynard Keynes is credited with saying:
“When the facts change, I change my mind.”
This is what FWP is doing.
Based on client-specific objectives, we may maintain some modest EM allocations but…
As an organization, we’ve concluded that the return, risk, and expense in terms of time and treasure associated with this asset class don’t justify an investment.
The potential to extract some EM juice isn’t worth the squeeze.
Related Reading:
Does Emerging Markets Investing Make Sense? – Wes Gray, PhD – Alpha Architect
Is Top Manager Performance and Random Walk? – Charlie Henneman, CFA
Staying Disciplined and Avoiding Unforced Errors 