Re-Examining Emerging Markets Equity

Jared Kizer offers five lessons that reinforce some of the reasons investors should remain committed to a long-term emerging markets equity allocation.

Emerging market equities have substantially underperformed the S&P 500 Index in 2018, with the S&P 500 up 6.5 percent and emerging markets down 4.4 percent through July. As I detailed in a recent post on international developed market equities, remaining committed to a globally diversified portfolio can be challenging during extended periods of underperformance relative to the U.S. market. In this post, we’ll look specifically at emerging markets by examining five lessons from long-run and current market data that reinforce some of the reasons investors should remain committed to emerging markets equity investing.

1. Over the long term, the evidence indicates that emerging market equities have outperformed U.S. equities.

From 1988 (the earliest data we have for emerging markets) through 2017, the S&P 500 earned average annual returns of 12.2 percent per year, while the MSCI Emerging Markets Index averaged 16.3 percent per year. In financial jargon, this difference in returns of roughly four percentage points would be referred to as a “risk premium,” indicating that markets have tended to reward long-term emerging markets investors with additional return compared to U.S. equities. This is a sensible result since emerging market equities clearly possess risks that U.S. equities do not. Emerging market investments could expose an investor to currency risk (the risk that emerging markets currencies as a group depreciate relative to the U.S. dollar), heightened geopolitical risk and lower market liquidity when compared to U.S. equities. Markets are aware of these additional risks and appear to have priced them appropriately.

2. Good news: While additional risks are associated with emerging markets investing, those risks are not perfectly correlated to U.S. equity market risk.

The three risks emerging markets investors face (outlined above) are either absent or lower for U.S. equities, but for globally diversified investors there’s a silver lining: Those risks are not perfectly correlated with the performance of U.S. equity markets. To visualize this, let’s look at a scatter plot of the annual returns of the U.S. and emerging equity markets.

Figure 1: MSCI Emerging Markets vs. S&P 500 Annual Returns (1988–2017)

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Source: Thomson Reuters Lipper

Because the points are fairly scattered and not on the line, this indicates an imperfect relationship between the returns of the two markets, indicating that owning both adds diversification to your portfolio.

3. Historically, a portfolio that included emerging market equities in addition to U.S. equities has had higher risk-adjusted returns than a U.S.-only portfolio.

We can also ask the question of what allocation to emerging markets has been historically optimal for an investor with a 100 percent allocation to equities who wanted to maximize risk-adjusted returns. In the investing world, this means we want to find the portfolio that provided the most return for the volatility it experienced. This is admittedly a theoretical exercise since we can’t go back in time and experience this portfolio (and we certainly can’t expect the future to be identical to the past), but it does give us a general indication of how useful emerging markets have been historically. Over the period 1988–2017, the optimal allocation was about 80 percent to the S&P 500 and 20 percent to emerging markets. This result doesn’t necessarily mean you should allocate 20 percent of your equity to emerging markets (that’s a conversation to have with your advisor regarding your comprehensive financial plan), but it is useful in showing an allocation of zero percent likely doesn’t make sense either.

4. As with international developed market equities, emerging market equities represent a sizable fraction of the world’s equity market wealth.

As of year-end 2017, emerging markets equities were a bit more than 12 percent of the world’s equity market value with total market capitalization of almost $7.2 trillion. As with the analysis above, this doesn’t necessarily mean your allocation should be 12 percent of your equity portfolio, but this is a reasonable starting point. As a very general rule, if the market’s allocation to an asset class is meaningful, then yours likely should be, too.

5. While emerging markets can be a valuable component of a diversified portfolio, be prepared for volatility and potentially long periods of time where it underperforms U.S. equities.

The first four points lay out the case for a long-term allocation to emerging markets. That said, over the shorter term, emerging markets will inevitably have periods when it dramatically outperforms the U.S. equity market and periods when it spectacularly underperforms the U.S. equity market. For investors who are tempted to look at relative performance over shorter periods of time, it helps to understand what you should expect to see. Let’s first look at year-by-year maximum drawdowns of the S&P 500 and the MSCI Emerging Markets. The maximum drawdown is the largest peak-to-trough loss an investment earns over a particular period of time. If we say that the maximum drawdown of the S&P 500 was –20 percent in 1993, that means there was some period of time in 1993 when the S&P 500 declined 20 percent. Figure 2 plots the maximum drawdown in each year from 1988–2017 for the S&P 500 and emerging markets.

Figure 2: S&P 500 and MSCI Emerging Markets Maximum Drawdowns (1988–2017)

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Source: Bloomberg

A few things stand out. First, in most years, the MSCI Emerging Markets Index has a drawdown of at least –10 percent and a significant number of years of at least –20 percent. Second, in most years, the maximum drawdown for emerging markets exceeds that of the S&P 500 (although they usually occur at different times during the year). This means investors with an allocation to emerging markets must remember it’s extremely volatile and will inevitably experience periods of substantial underperformance compared to the S&P 500. Let’s now look at rolling five-year returns for the S&P 500 and the MSCI Emerging Markets. Figure 3 presents this data.

Figure 3: Rolling 5-Year Annualized Returns (1988–2017)

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Source: Thomson Reuters Lipper

The first five-year period goes through 1992 and the last goes through 2017. I’ve specifically highlighted two of the five-year periods above to give a sense of the magnitude by which U.S. equities have outperformed emerging markets over a five-year period and vice versa. For the five-year period through 1999, the S&P 500 was up 28.6 percent per year, while emerging markets were up just 2 percent per year. Conversely, for the five-year period ending 2007, the S&P 500 was up 12.8 percent per year, while emerging markets were up 37.5 percent per year. These results are even more mind boggling when you remember that, over the entire period of 1988–2017, emerging markets outperformed the S&P 500 by an average of about 4 percent per year. This just goes to show that short-run results (though five years may feel long for some investors) can diverge from long-run results.

This commentary originally appeared September 6 on MultifactorWorld.com

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