Swedroe: Why Emerging Markets Matter

Investing in all risky assets requires discipline, as they all go through long periods of time where they dramatically underperform. This is certainly true of emerging markets. For example, emerging market equities have substantially underperformed the S&P 500 Index in 2018, with the S&P 500 up 6.5% and emerging markets down 4.4% through July.

My colleague and co-author, Jared Kizer, examined the evidence on emerging markets and the case for including them in a globally diversified portfolio. He looked specifically at emerging markets by examining five lessons from long-run and current market data that reinforce some of the reasons investors should remain committed to emerging market equity investing.

Following is his analysis.

1. Over the long term, the evidence indicates emerging market equities have outperformed U.S. equities.

From 1988 (the earliest data we have for emerging markets) through 2017, the S&P 500 earned average annual returns of 12.2% per year, while the MSCI Emerging Markets Index averaged 16.3% per year. In financial jargon, this difference in returns of roughly 4 percentage points would be referred to as a “risk premium,” indicating that markets have tended to reward long-term emerging market investors with additional return compared to U.S. equities. This is a sensible result, since emerging market equities clearly possess risks that U.S. equities do not. Emerging market investments could expose an investor to currency risk (the risk that emerging market currencies as a group depreciate relative to the U.S. dollar), heightened geopolitical risk and lower market liquidity when compared to U.S. equities. Markets are aware of these additional risks and appear to have priced them appropriately.

2. Good news: While additional risks are associated with emerging market investing, those risks are not perfectly correlated to U.S. equity market risk.

The three risks emerging market investors face (outlined above) are either absent or lower for U.S. equities, but for globally diversified investors, there’s a silver lining: Those risks are not perfectly correlated with the performance of U.S. equity markets. To visualize this, let’s look at a scatter plot of the annual returns of the U.S. and emerging equity markets.

Figure 1: MSCI Emerging Markets vs. S&P 500 Annual Returns (1988–2017)

Source: Thomson Reuters Lipper

Because the points are fairly scattered and not on the line, this indicates an imperfect relationship between the returns of the two markets, indicating that owning both adds diversification to your portfolio.

1. Historically, a portfolio that included emerging market equities in addition to U.S. equities has had higher risk-adjusted returns than a U.S.-only portfolio.

We can also ask the question of what allocation to emerging markets has been historically optimal for an investor with a 100% allocation to equities who wanted to maximize risk-adjusted returns. In the investing world, this means we want to find the portfolio that provided the most return for the volatility it experienced. This is admittedly a theoretical exercise, since we can’t go back in time and experience this portfolio (and we certainly can’t expect the future to be identical to the past), but it does give us a general indication of how useful emerging markets have been historically.

Over the period 1988–2017, the optimal allocation was about 80% to the S&P 500 and 20% to emerging markets. This result doesn’t necessarily mean you should allocate 20% of your equity to emerging markets (that’s a conversation to have with your advisor regarding your comprehensive financial plan), but it is useful in showing an allocation of 0% likely doesn’t make sense either.

2. As with international developed-market equities, emerging market equities represent a sizable fraction of the world’s equity market wealth.

As of year-end 2017, emerging market equities were a bit more than 12% of the world’s equity market value, with total market capitalization of almost $7.2 trillion. As with the analysis above, this doesn’t necessarily mean your allocation should be 12% of your equity portfolio, but this is a reasonable starting point. As a very general rule, if the market’s allocation to an asset class is meaningful, yours likely should be too.

3. While emerging markets can be a valuable component of a diversified portfolio, be prepared for volatility and potentially long periods of time where it underperforms U.S. equities.

The first four points lay out the case for a long-term allocation to emerging markets. That said, over the shorter term, emerging markets will inevitably have periods when it dramatically outperforms the U.S. equity market and periods when it spectacularly underperforms the U.S. equity market. For investors tempted to look at relative performance over shorter periods of time, it helps to understand what you should expect to see.

Let’s first look at year-by-year maximum drawdowns of the S&P 500 and the MSCI Emerging Markets. The maximum drawdown is the largest peak-to-trough loss an investment earns over a particular period of time. If we say that the maximum drawdown of the S&P 500 was –20% in 1993, that means there was some period of time in 1993 when the S&P 500 declined 20%. Figure 2 plots the maximum drawdown in each year from 1988–2017 for the S&P 500 and emerging markets.

Figure 2: S&P 500 and MSCI Emerging Markets Maximum Drawdowns (1988–2017)

Source: Bloomberg

A few things stand out. First, in most years, the MSCI Emerging Markets Index has a drawdown of a least –10% and a significant number of years of at least –20%. Second, in most years, the maximum drawdown for emerging markets exceeds that of the S&P 500 (although they usually occur at different times during the year).

This means investors with an allocation to emerging markets must remember it’s extremely volatile and will inevitably experience periods of substantial underperformance compared to the S&P 500. Let’s now look at rolling five-year returns for the S&P 500 and the MSCI Emerging Markets. Figure 3 presents this data.

Figure 3: Rolling 5-Year Annualized Returns (1988–2017)

Source: Thomson Reuters Lipper

The first five-year period goes through 1992 and the last goes through 2017. I’ve specifically labeled two of the five-year periods above to give a sense of the magnitude by which U.S. equities have outperformed emerging markets over a five-year period and vice versa.

For the five-year period through 1999, the S&P 500 was up 28.6% per year, while emerging markets were up just 2% per year. Conversely, for the five-year period ending 2007, the S&P 500 was up 12.8% per year, while emerging markets were up 37.5% per year.

These results are even more mind boggling when you remember that, over the entire period of 1988–2017, emerging markets outperformed the S&P 500 by an average of about 4% per year. This just goes to show that short-run results (though five years may feel long for some investors) can diverge from long-run results.

In my next post, I'll examine the evidence on whether active management is the winning strategy in emerging markets.

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