First I will make the medium-to-long-term bear case against emerging markets. Then I’ll explain why you probably shouldn’t really care.
There are plenty of things not to like about emerging markets.
Recent performance tops the list. The benchmark iShares Emerging Markets index is down nearly 6% in a month and has underperformed the S&P 500 index by more than 30 percentage points so far this year. Emerging market bonds too have been hit, with the iShares JP Morgan USD Emerging Market Bond falling more than 12% in 2013.
And there are good reasons to think the carnage is not complete. China, as shown in its recent dismal trade figures, is slowing alarmingly rapidly. That won’t just hurt investments there, but will pressure many of the resource-rich emerging markets like Russia and Brazil which have reaped the rewards of a strong appetite from China for food, energy and other commodities. The IMF on Tuesday cut its growth forecasts for most major emerging markets, and cited weakness among them as justification for a weaker outlook for the rest of the world.
What’s more, any decision by the Federal Reserve to begin to taper its bond-buying activities, something many expect as early as September, may hit emerging markets disproportionately. Think of QE, in all its manifestations, as an enticement to investors to buy risky securities. The riskier the security the more it benefits, something we’ve seen in recent years as risk premiums for emerging market stocks and bonds have dropped. If QE begins to be slowed, or eventually reversed, that will hurt.
Finally, a trend towards re-shoring of manufacturing back to the US and other developed countries may well be a drag on emerging market growth over the long term. Cheap and abundant energy in the US, as well as a narrowing in the cost of production and the use of new technology are prompting some to believe that we will see ongoing migration of factories back to the US. Clearly, that won’t be good for China, and, as US production is less commodity-intensive, won’t be good for many other emerging markets as well.
Diversification for the long run
So, it may be reasonable to expect poor returns out of emerging markets but that is a far different thing than saying most investors should sell. By all means if you have a big overweight in emerging markets, perhaps driven by the relative outperformance of the past 10 years, now might be a good time to shave that back.
But that is not where most investors are. Indeed, few advisers tell investors to allocate even as much as 10% to emerging market stocks, even for self-professed ‘aggressive’ investors. That’s light considering that emerging markets are about 13% of global market capitalisation, and account for nearly 40%t of global GDP.
But the big reason to stay neutral on emerging markets is the old, reliable and unchanging benefit which comes from a diversified portfolio.
Looking at what they said was a more complete set of data on emerging market equities than previous studies, Mitchell Conover of University of Richmond, Gerald R. Jensen of Northern Illinois University and Robert R. Johnson of Creighton University found in a 2012 paper that the hedge benefits of emerging markets may have been underestimated.
“Overall, our findings indicate that emerging markets allow investors to achieve lower risk, higher returns, and expanded risk/return possibilities; especially during periods when developed world investors need diversification the most,” they write.
Using one common measure of risk-adjusted return, the authors find that emerging markets offer about double what developed ones do, with the particular advantage of less downside.
Diversification, of course, works both ways, and a period in which emerging markets are not well correlated with developed ones and underperform may well simply be an example of diversification in action.
Diversifying makes your portfolio outperform because it lowers volatility, allowing you to take on more risk than you otherwise would dare. By its nature, it involves holding things which go down when other things go up.
And right now diversification means holding on to emerging market positions even though you “know,” in your heart of hearts, that they will do poorly.
(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. firstname.lastname@example.org)