Many investors fell for emerging markets in recent years when they delivered sizeable returns. More recently, the associated risk has reasserted itself and the infatuation has faded. What’s the right approach?
A major theme in media commentary since the turn of the century has been the prospect of a gradual passing of the baton in global economic leadership from the world’s most industrialized nations to the emerging economies.
Anticipating this change, investors have sought greater exposure to these changing economic forces by including in their portfolios an allocation to some of the emerging powerhouses such as China, India and Brazil.
These markets historically have provided higher average returns than developed markets.
But the flipside of these returns is that emerging markets also tend to be riskier and more volatile. This is reflected in their higher standard deviation of returns, which is one measure of risk.
The risk associated with emerging markets has reasserted itself in recent months. Expectations that the U.S. Federal Reserve will “taper” its monetary stimulus have led to a retreat by many investors from these developing markets.
In its latest economic assessment released in September, the Organization of Economic Cooperation and Development (OECD) noted that while advanced economies were growing again, some emerging economies were slowing.1
Naturally, many investors will be feeling anxious about these developments and wondering whether emerging markets still have a place in their portfolios. There are number of points to make in response to these concerns.
First, this information is in the price. Markets reflect concerns about the impact of the Fed’s tapering on capital flows. Changing a portfolio allocation based on past events is tantamount to closing the stable door after the horse has bolted.
Second, just as rich economies and markets like the U.S., Japan, Britain and Australia tend to perform differently from one another, emerging economies and markets tend to perform differently from rich ones.
This just means that irrespective of short-term performance, emerging markets offer the benefit of added diversification. And we know that historically, diversification across securities, sectors, industries and countries has been a good source of risk management for a portfolio.
Third, emerging markets perform differently from one another, and it is extremely difficult to predict with any consistency which countries will perform best and worst from year to year. That’s why concentrated bets are not advised. Fourth, in judging your exposure to emerging markets, it is important to distinguish between a country’s economic footprint and the size of its market. Combined, emerging markets make up only 11% of the total world market.
This is not to downplay the importance of emerging markets. The global economy is changing, and the internationalization of emerging markets in recent decades has allowed investors to invest their capital more broadly. Emerging markets are part of that.
We know that risk and return are related, so getting out of emerging markets or reducing one’s exposure to them after stock prices have dropped means forgoing the increased expected return potential.
A bumpy ride on this tiger is not unexpected. But for those adequately diversified with an asset allocation set for their needs and risk appetites, it is worth holding on.
