Swedroe: EM Looks Terrible—Time To Buy

March 02, 2016

From 2008 through 2015, the S&P 500 Index returned 6.5% per year, providing a total return of 66%. During the same period, the MSCI Emerging Markets Index lost 2.8% a year, providing a total return of -21%. It managed to underperform the S&P 500 Index by 9.3 percentage points a year, and posted a total return underperformance gap of 87 percentage points.

Not only were investors earning much lower returns from emerging market stocks, they were experiencing much greater volatility. While the annual standard deviation of the S&P 500 Index was about 21%, the MSCI Emerging Markets Index experienced volatility of about 38% a year. Not exactly a great combination—lower returns with almost twice the volatility. What’s to like?

EM Underperformance Continues

And the start to this year hasn’t been any better. The performance gap has widened a bit further as, through Feb. 24, the S&P 500 Index lost 5.3%, while the MSCI Emerging Markets Index lost 6.6%.

The comparisons get even worse if we look at the latest five-year returns. For the period ending Feb. 24, 2016, Vanguard’s 500 Index Fund (VFINX) returned 10.3% per year while its Emerging Markets Index Fund (VEIEX) lost 5.2% per year, a performance gap of 15.5 percentage points per year.

Unfortunately, it’s been 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.

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 managing to underperform the very funds in which they invest. What’s the explanation for this irrational behavior?

Recency Bias

Among the 77 errors discussed in my book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” is one called “recency.” Recency is the tendency we have to overweight recent events/trends and ignore long-term evidence. This can result in behavior opposite to what a disciplined investor should be doing (rebalancing) to maintain their portfolio’s asset allocation. Disciplined rebalancing produces the concave strategy.

The problem created by recency is only compounded when emerging market stocks are the underperforming asset, because such situations greatly increase the risk that an investor will make an error. The reason for this is another of the 77 mistakes I cover. Confusing familiarity with safety can lead to a home-country bias.

Further compounding the problem is that 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 returned 12.8% a year, the MSCI Emerging Markets Index managed to return 37.5%, outperforming by 24.7 percentage points a year. Looking at their total returns presents an even more dramatic picture: the S&P 500 Index returned 82.9% versus 390.8% for the emerging markets index. How quickly investors forget!

Given these dramatic differences in returns, it has been very difficult for investors to stay disciplined. My message is that these types of divergences in returns are to be expected (though they happen in unexpected ways). We diversify across the globe because we don’t have clear crystal balls that can tell us which will be the best-performing countries—and neither does anyone else.

There will almost certainly be periods when U.S. stocks underperform. There will just as certainly be periods when they outperform. The key to being a successful investor isn’t, as Wall Street and much of the financial media would like you to believe, about being able to accurately forecast which asset will do well when.

Instead, it’s about remaining disciplined and adhering to your asset allocation plan. That means having the courage to rebalance to your target allocations, buying what has done poorly and selling what has done well—and that’s something a lot of investors are unable to do on their own.

Hopefully, by doing a forward-looking—instead of a backward-looking—analysis, I can help you stay disciplined.

Current Valuations And Expected Returns

The best predictors we have of future returns are current valuations. With that in mind, the table below provides the valuation metrics of VFINX and VEIEX. Data is from Morningstar as of Jan. 31, 2016.

Fund Price/Earnings Price/Cash Flow Price/Book Value Price/Sales
VFINX 16.6 9.2 2.4 1.7
VEIEX 11.4 3.7 1.3 1.1

As you can see, regardless of which value metric we look at, U.S. valuations are now much higher than emerging market valuations. Now, it’s important to understand that doesn’t make international investments a better choice. Their higher valuations simply reflect the fact that investors view the U.S. as a safer place to invest. And, as you know, there’s an inverse relationship between risk and expected returns (at least there should be).

That said, a common method used by financial economists (as opposed to methods used by gurus gazing through their crystal balls) of estimating future real expected returns is to use the earnings yield, or E/P, the inverse of the more commonly used price-to-earnings (P/E) ratio. That method produces an expected real return for U.S. stocks of about 6%, which compares with an expected real return of 8.8% for emerging market stocks.

Another commonly used metric to forecast future returns is the Shiller Cyclically Adjusted Price Earnings Ratio, or CAPE 10 ratio. This metric uses the last 10 years of earnings and adjusts them for cumulative inflation.

The S&P 500 currently has a CAPE 10 of about 24.4, producing an earnings yield of 4.1%. To adjust for the fact that real earnings grow about 2% per year over time, and that we are looking at earnings that are on average five years old, we must multiply 4.1% by 1.1—or [1 + (2% x 5)]—to arrive at our forecast of real returns of 4.5%.

So how does this compare to emerging markets valuations? At least one fund manager thinks that the recent poor performance of emerging markets has made valuations so low that they are now “the trade of a decade.”

In a post on PIMCO’s website, Christopher Brightman, chief investment officer at Research Affiliates, the sub-advisor for PIMCO’s All Asset Fund, observed that the cyclically adjusted price-to-earnings ratio fell to 10 in January. He further noted that there have been only six times when the measure has dipped below 10 over the past 25 years. In the following five years, the stocks rallied an average 188%.

Brightman then made the following important observation: “From the rearview mirror, the bear market in emerging markets has been painful. When we look out of the windshield, however, these very asset classes offer the highest potential returns available.”

Making The Case For Global Diversification

Diversification rightly has been called the only free lunch in investing. A portfolio of global equity markets should be expected to produce a superior risk-adjusted return to any one country, or region, held in isolation. However, the benefits of global diversification came under attack as a result of the financial crisis of 2008, when all risky assets suffered sharp price drops as their correlations rose toward 1.

Many investors took the wrong lesson—that global diversification doesn’t work because it fails when its benefits are needed most—from what happened. This is wrong on two fronts.

First, the most critical lesson investors should have learned is that, because correlations of risky assets tend to rise toward 1 during systemic global crises, the most important type of diversification is to ensure your portfolio has a sufficiently high allocation to the safest bond investments (investments such as U.S. Treasury bonds, FDIC-insured CDs and municipal bonds rated AAA/AA) so that your overall portfolio’s risk is dampened to the level appropriate to your ability, willingness and need to take risk.

During systemic financial crises, the correlations of the safest bonds to stocks—which average about zero over the long term—tend to turn sharply negative (the time when they’re needed most). They benefit from not only flights to safety, but also from flights to liquidity.

Second, many investors failed to understand that, while international diversification doesn’t necessarily work in the short term, it does work eventually. This point was the focus of a paper by Clifford Asness, Roni Israelov and John Liew—“International Diversification Works (Eventually)”—which appeared in the May/June 2011 edition of Financial Analysts Journal.

The Eventual Benefits Of Diversification

The authors explained that those who focus on the fact that globally diversified portfolios don’t protect investors from short systematic crashes miss the greater point that investors whose planning horizon is long term (and it should be, or you shouldn’t be invested in stocks to begin with) should care more about long, drawn-out bear markets, which can be significantly more damaging to their wealth.

In their study, which covered the period 1950 through 2008 and 22 developed-market countries, the authors examined the benefit of diversification over long-term holding periods.

They found that over the long run, markets don’t exhibit the same tendency to suffer or crash together. As a result, investors should not allow short-term failures to blind them to long-term benefits. To demonstrate this point, the authors decomposed returns into two pieces: (1) a component due to multiple expansions (or contractions); and (2) a component due to economic performance.

From there, they found that while short-term stock returns tend to be dominated by the first component, long-term stock returns tend to be dominated by the second. They explained that these results “are consistent with the idea that a sharp decrease in investors’ risk appetite (i.e., a panic) can explain markets crashing at the same time. However, these risk aversion shocks seem to be a short-lived phenomenon. Over the long-run, economic performance drives returns.”

They further showed that “countries exhibit significant idiosyncratic variation in long-run economic performance. Thus, country specific (not global) long-run economic performance is the most important determinant of long-run returns.”

For example, in terms of worst-case performances, they found that at a one-month holding period, there was very little difference in performance between home-country portfolios and the global portfolio. However, as the horizon lengthens, the gap widens. The worst cases for the global portfolios are significantly better (meaning the losses are much smaller) than the worst cases for the local portfolios. And the longer the horizon, the wider the gap favoring the global portfolio becomes.

Demonstrating the point that long-term returns are more about a country’s economic performance, and that long-term economic performance is quite variable across countries, the authors found that “country specific economic performance dominates long-term performance, going from explaining about 1% of quarterly returns to 39% of 15-year returns and rising quite linearly in time.”


We live in a world where there are no clear crystal balls. Thus, the prudent strategy is to build a globally diversified portfolio. But that’s simply the necessary condition for success.

The second part, the sufficient condition, is to possess the discipline to stay the course, ignoring not only the clarion cries from those who think that their crystal balls are clear, but also the cries from your stomach to GET ME OUT! As Warren Buffett explained, “The most important quality for an investor is temperament, not intellect.”

To help you stay disciplined and avoid the consequences of the dreaded investment disease known as recency, I offer the following suggestion: Whenever you are tempted to abandon your well-thought-out investment plan because of poor recent performance, ask yourself this question: Having originally purchased and owned this asset when valuations were higher and expected returns were lower, does it make sense to now sell the same asset when valuations are currently much lower and expected returns are now much higher?

The answer should be obvious. And if that’s not sufficient, remember Warren Buffett’s advice to never engage in market timing, but if you cannot resist the temptation, then you should buy when others are panicked and selling.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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