Swedroe: Emerging Markets Need Time

May 10, 2019

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.

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