Swedroe: Emerging Markets Need Time

May 10, 2019

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.

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