Swedroe: Don’t Underestimate Emerging Markets

March 22, 2017

Thirty years ago, emerging markets made up about 1% of world equity market capitalization and just 18% of GDP. As such, there was a very limited ability to invest in emerging markets—the few funds that were 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 the global GDP. And the costs of obtaining exposure to emerging markets has significantly decreased. For example, the expense ratio of Vanguard’s Emerging Markets Stock Index Fund (VWO) is just 0.14%.

Yet despite representing about one-eighth of global equity market capitalization, the vast majority of investors have much smaller allocations (they dramatically underweight) to emerging market stocks. The 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, Lake Wobegon exists only in fiction. It cannot be that every developed country is safer than the others. Compounding the problem, investors tend to believe that not only is their home country a safer place to invest, but 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—allowing more recent returns to dominate their decision-making. From 2008 through 2016, the S&P 500 Index returned 7.1% per year, providing a total return of 85.5%.

During the same period, the MSCI Emerging Markets Index lost 1.3% a year, providing a total return of -11.3%. It managed to underperform the S&P 500 Index by 8.4 percentage points per year and posted a total return underperformance gap of 96.8 percentage points.

Compounding the problem was that not only were investors earning much lower returns from emerging market stocks but that they were experiencing much greater volatility. While the annual standard deviation of the S&P 500 Index was about 16% per year, that of the MSCI Emerging Markets Index was about 24% per year. Not exactly a great combination—lower returns with 50% greater volatility. What’s to like?

Investors’ Self-Destructive Tendencies
Unfortunately, it’s well-documented that individuals have a strong tendency to invest in a manner destructive to their returns. The illustration below depicts the difference between “convex” and “concave” investing behavior.

 

 

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