Swedroe: Don’t Exclude Emerging Markets

April 16, 2018

Thirty years ago, emerging markets made up only about 1% of world equity market capitalization, and just 18% of global GDP. As such, the ability to invest in emerging markets was limited—the few funds available were high-cost, actively managed funds.

Today the world looks very different. Emerging markets represent about 13% of global equity capitalization, and more than half of global GDP. In addition, the cost of obtaining exposure to emerging markets has decreased considerably. The expense ratio of Vanguard’s Emerging Markets Stock Index Fund Admiral Shares (VEMAX), for example, is just 0.14%.

Two Common Mistakes       

Yet despite emerging market stocks representing about one-eighth of global equity market capitalization, the vast majority of investors has much smaller allocations to them, dramatically underweighting the asset class. This underweighting often is a result of two mistakes.

The first, and most prominent, is the well-known home country bias, which causes investors all around the globe to confuse familiar investments with safe investments. Unfortunately, it cannot be that every developed country is safer than the others. Compounding the problem, investors tend to believe not only that their home country a safer place to invest, but also that it will produce higher returns, defying the basic financial concept that risk and expected return are related.

The second mistake is that investors are subject to recency bias—allowing more recent returns to dominate their decision-making. From 2008 through 2017, the S&P 500 Index returned 8.5% per year, providing a total return of 126%. During the same period, the MSCI Emerging Markets Index returned just 2.0% a year, providing a total return of 22%. It managed to underperform the S&P 500 Index by 6.5 percentage points per year, and posted a total return underperformance gap of 104 percentage points.

Not only were investors earning much lower returns from emerging market stocks, they also were experiencing much greater volatility. While the annual standard deviation of the S&P 500 Index was about 15% per year, the MSCI Emerging Markets Index’s standard deviation was about 23% per year. Not exactly a great combination—lower returns with more than 50% greater volatility. What’s to like?

The illustration below depicts the difference between “convex” and “concave” investing behavior.

 

While investors know that buying high and selling low isn’t a good strategy, the research shows that individual investors tend to buy after periods of strong performance (when valuations are higher and expected returns are thus lower) and sell after periods of poor performance (when valuations are lower and expected returns are thus higher). Research has found this destructive behavior has led to investors underperforming the very funds in which they invest.

Furthermore, investors tend to have short memories. For example, it wasn’t long ago that investors were piling into emerging market equities due to their strong performance. For the five-year period 2003 through 2007, while the S&P 500 Index provided a total return of 83%, the MSCI Emerging Markets Index returned 391%. How quickly investors forget!

Drivers Of EM Risk & Return

Roberto Violi and Enrico Camerini contribute to the literature on emerging markets with the study “Emerging Market Portfolio Strategies, Investment Performance, Transaction Cost and Liquidity Risk.” The goal of their study, which was originally written in August 2016 but published on SSRN in March 2018, was to explore the prominent drivers of risk and return in emerging markets. They noted that emerging markets (EM) have the attractive qualities of high average returns and low correlation with developed markets (DM).

However, global markets have become more integrated, and correlations have risen. In addition, as EM have grown and become more investable, with implementation costs having fallen, the risk premium should also have come down. The question is whether the current empirical evidence would still suggest there is a significant benefit to including EM assets in a globally diversified portfolio.

Following is a summary of their findings:

 

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