Swedroe: Emerging Markets Need Time

The April 26, 2019 column by John Rekenthaler, vice president of research at Morningstar, called the experiment of investing in emerging markets a failure. He drew this conclusion after presenting the following evidence.

He began by showing the correlation between the Vanguard Emerging Markets Stock Index (VEIEX) and the S&P 500 Index over the last 25 years was a fairly low 0.25, demonstrating that, “On paper, emerging-markets stock funds did do some zigging while U.S. equities zagged.”

However, he then noted that it was “useless diversification. The only two times during the GREAT BULL MARKET (the results warrant the capitalization) in which U.S. equity investors needed protection was the New Era technology-stock meltdown and, of course, 2008. Emerging-markets stocks dropped 25% during the first instance—better than the S&P 500 but roughly in line with Vanguard Value Index (VIVAX)—and crashed even harder during the second. There was no zigging; only zagging.”

He added: “The main reason that the correlation statistic is modest was because emerging-markets stocks nosedived during the mid-90s, when U.S. equities were booming. Great. If you seek diversification with something that heads south when the rest of your portfolio is thriving, and that goes down along with everything else when the bear market arrives, then emerging-markets stock funds are the asset class for you.”

This view—that emerging markets diversification failed when needed most—misses the point that, while international diversification doesn’t necessarily work in the short term, it eventually works. 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 the Financial Analysts Journal.

Diversification For The Long Term

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 they 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 of 22 developed market countries during the period 1950 through 2008, 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 components: 1) those due to multiple expansions (or contractions); and 2) those due to economic performance.

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.” While this study focused on developed markets, the same issues apply to emerging markets.

To be fair, Rekenthaler noted that in “one stretch, during the aughts … developed markets stocks rose moderately, while emerging-markets stocks soared.” However, he noted that “A $10,000 investment in Vanguard's emerging-markets stock fund at its [June] 1994 launch would now be worth $47,000. Buying an S&P 500 index fund instead would have yielded just over $100,000. Emerging-markets funds were intended to bring greater rewards, over the long haul, and they have not done that. … The experiment was tried, and it failed.”

Before you accept that conclusion, let’s review a few key points; the first being that, when looking at a data series, we need to be careful, because the results could be very sensitive to starting and end points, especially when valuations are either very high or very low relative to historic averages. Note that “multiple expansions and contractions” was one of the two return components Asness, Israelov and Liew examined.

Starting, End Dates Matter

Rekenthaler chose to compare the results from the start date (1994) of the Vanguard Emerging Markets Index fund. That seems reasonable. However, we have data for the MSCI Emerging Markets Index going back to 1988. If we use that as our starting point, from January 1988 through March 2019, the MSCI index’s return of 10.67% per annum slightly outperformed the S&P 500 Index’s return of 10.54%. Similar returns combined with less than perfect correlation would have provided a further portfolio benefit, assuming rebalancing.

Second, the period Rekenthaler used happens to be one in which the last 10 years have seen much stronger performance for the U.S. than for emerging markets, which certainly could be a random outcome. And it’s important to note that this outperformance has led to a dramatic difference in valuations, which are the best predictors of future returns.

For example, Morningstar shows VEIEX’s forward-looking P/E ratio as of March 31, 2019, to be 11.9 versus 17.1 for that of Vanguard 500 Index Fund (VFINX). In addition, the CAPE 10 as of March 31, 2019, was about 31 for the S&P 500, more than double that of the 14.7 of the MSCI Emerging Markets Index. Data is from AQR Capital Management.

While we only have CAPE 10 data on the emerging markets back to 1996, there are two observations we can make. At the start of the period, the CAPE 10 for the S&P 500 was 26.3, and 27.0 for the emerging markets. While U.S. returns benefited from the multiple expansion, emerging markets returns were negatively impacted.

It’s also worth noting the current CAPE 10 for emerging markets of 14.7 is not much higher than the 12.2 CAPE 10 reached in February 2009, at the bottom of the Great Financial Crisis. And the lowest CAPE 10 for emerging markets was 11.5 (August 2016). The bottom line is that, in terms of earnings, while U.S valuations remain relatively high, emerging market valuations are near the lowest levels. (Data is from AQR.)

In terms of valuations and their use as predictors of future returns, we can also look to the evidence on the book-to-market ratio.

Importance Of Book-To-Market Ratio

Michael Keppler and Peter Encinosa, authors of “How Attractive Are Emerging Markets Equities? The Importance of Price/Book-Value Ratios for Future Returns,” which appeared in the Spring 2017 issue of The Journal of Investing, provide us with further insights as to returns we might expect from emerging markets.

For the period January 1989 through October 2016, they found that the price-to-book (P/B) ratio of the MSCI Emerging Markets Index ranged from a low of 0.90 in January 1989 to a high of 3.02 in October 2007, and averaged 1.75. They then divided the P/B range into three intervals and found:

• For 10 observations, the P/B ratio was below 1.22. The average annual return in U.S. dollars in the four years that followed was 12.9% and never fell below zero.
• For 273 observations in the second interval, the P/B fell between 1.22 and 2.76. The average annual return in the four years that followed was 9.4%.
• In four observations, the P/B ratio exceeded 2.76. The average annual return in the four subsequent years was -5.1%, and was always negative.

Morningstar reports the current P/B ratio of VEIEX is 1.54, near the bottom of the range for the interval during which the MSCI Emerging Markets Index returned 9.4% over the succeeding four years, and not far above the interval that produced 12.9% returns over the succeeding four years. I would add that the P/B of the DFA Emerging Markets Value Portfolio (DFEVX) is just 0.87 (versus 2.1 for VIVAX). Again, the low P/Bs for the emerging markets funds reflect their relatively poor performance over the last 10 years.

On the other hand, the P/B of VFINX is almost 3 (2.97), reflecting its strong performance over the last 10 years. This is important, because Keppler and Encinosa also found the same negative relationship between the P/B ratio and returns in the subsequent four years in the developed markets.

Broader Time Period

Over the period 1970 through October 2016, the authors found the lowest P/B ratio was l.01 in July 1982, the highest was 4.23 in December 1999 and the average was 2.06. Again, dividing the period into three intervals, they found:

• For 169 observations, the P/B ratio was below 1.70. The average annual return in U.S. dollars in the four years that followed was 15.4% and was never below zero.
• For 319 observations, the P/B ratio was between 1.70 and 3.46. The average annual total return four years later was 7.2%.
• For 27 observations when the P/B ratio was above 3.46, the average annual return over the next four years was -5.6% and was always negative.

As you can see, the current P/B of VFINX (2.97) is near the top of the middle range where future returns were below average, and not that far from the bottom of the range from which future returns were negative. (Note that, unfortunately, the authors did not choose to break the data into quartiles or quintiles, and thus the P/B ratios chosen raise a concern of data mining).

The bottom line is that the period Rekenthaler examined ends with relatively high valuations for U.S. stocks and relatively low valuations for emerging markets stocks, reflecting their relative performances over the most recent decade.

Thus, expected returns among emerging market equities, particularly emerging market value stocks, are much higher than they are for U.S. stocks (as well as those in other developed markets, though to a lesser degree). And one of the worst behaviors investors exhibit is performance chasing—buying after long periods of strong performance and selling after long periods of weak performance. This is not a mistake you want to make.

At the same time, it’s important to remember that the higher expected returns of emerging markets are by no means a free lunch—they come with greater risks.

Before concluding, there’s a third point we need to discuss regarding Rekenthaler’s analysis.

Emerging Market Value & Small Stocks

In addition to total market funds, such as VEIEX, we can also look at the returns of another live, emerging market fund (one I personally invest in) that my firm recommends for inclusion in portfolios, which happens to have an earlier inception date than VEIEX: Dimensional’s DFEVX.

The fund not only provides access to emerging markets in a passive (no individual security selection or market timing) manner, but also to the value factor, which provides an expected premium. Over the period from inception in March 1993 through March 2019, DFEVX returned 10.92%, outperforming the 9.53% return of the S&P 500 Index and the 9.54% return of the MSCI U.S. Prime Market Value Index. Over this period, the MSCI Emerging Markets Index returned 7.31%.

We can also examine the performance of Dimensional’s Emerging Markets Small Cap Fund (DEMSX). Over the 21-year period from inception in April 1998 through March 2019, DEMSX returned 10.6%, outperforming the S&P 500 Index by 4% per annum and the MSCI Small Cap 1750 Index by 1.9% per annum.

Based on his analysis, Rekenthaler concluded that if you were going to invest in emerging markets, it is “best to let the professional managers make the decisions. They can incorporate companies from emerging markets as they see fit—greatly, modestly, or not at all, depending upon how their funds are defined and (for actively managed portfolios) their views on the trade-off between 1) higher-growth opportunities and 2) stronger corporate governance.”

Let’s see if the data supports that conclusion. We’ll begin with tackling the stronger corporate governance issue.

Governance & Returns

In their study published in the 2015 Credit Suisse, Global Investment Returns Yearbook, Elroy Dimson, Paul Marsh and Mike Staunton examined the impact of screening out countries based on their degree of corruption. Countries were evaluated using the Worldwide Governance Indicators from a 2010 World Bank policy research working paper from Daniel Kaufmann, Aart Kraay and Massimo Mastruzzi, “The Worldwide Governance Indicators: Methodology and Analytical Issues.” The indicators comprise annual scores on six broad dimensions of governance.

Dimson, Marsh and Staunton found 14 countries that posted a poor score, 12 that were acceptable, 12 that were good and 11 with excellent scores. Post-2000 returns for the last three groups were between 5.3% and 7.7%. In contrast, the markets with poor control of corruption had an average return of 11.0%.

Interestingly, realized returns were higher for equity investments in jurisdictions that were more likely to be characterized by corrupt behaviors. As the authors note, the time period is short, and the result might just be a lucky outcome. On the other hand, it’s also logical to consider that investors will price for corruption risk and demand a premium for taking it!

We’ll now turn to Rekenthaler’s recommendation that you hire active managers if you’re going to invest in emerging markets.

Is Active Management The Answer?

One way active management could add value is by timing its entry and exit into emerging markets. How likely is that to show value added?

Here’s one bit of evidence that, at the very least, suggests there is a huge hurdle to overcome. From 1988 through 2018, the MSCI Emerging Markets Index (gross of dividends) returned 10.4%. The best 31 months of that 31-year period provided an average return of 12.5%, while the other 341 months returned 0.0%. The best 31 months (an average of just one month a year) provided more than 100% of the annualized returns. That would seem to make timing a daunting task. And keep in mind, Warren Buffett advises against trying to time markets.

The other way active management could add value is through stock picking and country selection, possibly combined with market timing. In its 2018 Annual SPIVA Scorecard, S&P found that 96% of actively managed funds in this supposedly inefficient asset class underperformed over the prior 15 years. And that is on a pretax basis.

Given that, for taxable investors, the greatest cost of active management is typically taxes—not the expense ratio—the odds of outperformance are even lower. I don’t like those odds.

Summary

Emerging markets are riskier than developed markets. As such, they should have higher expected returns. That includes the risk of weaker corporate governance. The fact that they did not outperform over the period examined by Rekenthaler should not have caused investors to abandon their belief that riskier assets should have higher expected returns.

The more likely answer is that the risks just happened to show up. There are many examples of risky assets underperforming for very long periods, longer than the one Rekenthaler considered. Consider the following:

• Over the 40-year period 1969 through 2008, the Fama-French large cap growth research index returned 8.5%, and the Fama-French small growth research index returned 4.74%. Both underperformed the 8.9% return of long-term U.S. government bonds.
• Over the 29-year period 1990 through 2018, Japanese large cap stocks provided a total return of -0.03%.

We diversify across assets with unique sources of risk and return because we don’t have a crystal ball that allows us to foresee the future. And no gurus have one either. If you are not experiencing pain across some part of your portfolio, it’s likely you are not sufficiently diversified. The reason is that if all assets are doing well at the same time, it’s likely they can also do poorly at the same time. That’s why diversification is simple in concept but difficult in practice.

Finally, viewing the evidence without considering that it might have been just a random outcome makes the mistake that Nicholas Nassim Taleb described in the following way: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”

The bottom line is that emerging markets now make up about one-eighth of the global market capitalization. That is a good starting point for setting your emerging markets allocation. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.