Re-Emerging Markets?

Given the recent performance of the US stock market, some investors have been questioning the virtues of diversification.  These virtues are challenged the most when a well-publicized index such as the S&P 500 index outperforms most other sectors of the market.  However, it is important to realize that differences in performance are precisely why you diversify.

For example, one sub-class that has struggled recently relative to the S&P 500 is emerging market equities.   First, let’s define what “emerging markets” are exactly.  Emerging market economies are defined as economies that have low to middle per capita income.  A misconception is that they are classified on the size of their GDP.  A simple example is that of China, with a current GDP larger than the United States, still being considered an emerging market economy.  As a matter of fact, these emerging market countries represent 80% of the global population and only about 20% of the world’s GDP.  They tend to have higher growth in GDPs, but studies show that GDP growth may not be correlated to stock market returns (an argument for another day).

Emerging market economies are often considered transitional economies embarking on economic development and reform programs to “open” their markets to outside investors.  Outside investors include both foreign businesses located within the country and investors in the local capital markets of the country.  Investments in these countries come with a litany of risks.  During the late 1990’s many were bitten by the “Asian Flu” which caused local currencies to slump, effectively devaluing their stock markets and other asset prices within these countries.  This has caused many emerging markets such as China to effectively “peg” their local currency to a more stable currency (the dollar) in order to avoid this from happening again.  Other risks such as the political risks recently seen in Hong Kong, natural resource risks seen in the Middle Eastern countries with the falling prices of oil, inflation risks inherent in India, and geopolitical sanction risks seen most recently in Russia are causes of volatility.

With all of these economic, geographical, and political risks it’s easy to see why returns of these markets are so volatile.  However, like anything else, risk and return are related.  So why have the emerging markets countries lagged behind the United States of late when they are riskier and the world economy is getting better?  For that answer it’s important to have longer-term perspective.  Examining the returns below, you can see the drastic differences in both recent and longer-term performance of emerging markets and large-cap US stocks.

If we compare the annual returns using an October end date, you can see how volatile yearly returns have been since 2000 in the emerging markets sector.  Just using a simple eye test, you gleen the year-to-year volatility that you don’t necessarily see on the annualized returns over longer periods.

Further comparing annual emerging market returns to the S&P 500, you see very different performance on an annual basis.  The average difference in performance on an annual basis over these 15 years ending in October 2014 was 21.41%!  In fact, there were only three years when returns were within 10% of each other (2001, 2004 & 2010).

In investment jargon, this is what we call non-correlation.  This is precisely what you want when you are trying to reduce the overall volatility of a portfolio.  While these wouldn’t be the only two assets in a diversified portfolio, the example shows why the combination could bring volatility down.

While there are no guarantees, history shows us that emerging markets returns will probably come back, and when they do it will be in material movements.  This is why rebalancing is so paramount to long-term portfolio returns, and explains why emerging markets are amongst our most traded and volatile assets in a diversified portfolio.  You obviously want to reduce exposure after it moves sharply upward relative to other assets and conversely, buy more when they are lagging other assets (buy low, sell high anyone?).

In conclusion, emerging markets stocks have an important place in a portfolio of diversified equities.  Volatility is the price we pay for higher returns.  While recent returns in emerging markets have been muted, history shows us the volatility will return and with that higher returns.  As an investor, you must have the stomach and the patience to wait for it, but it also helps to have other asset classes with low correlations to help your overall portfolio performance while you are waiting!

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Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.