If ever there was a corner of the equity market that’s teased and tormented clients for extended periods of time, it’s emerging markets.
From the start of this century through the global financial crisis, emerging markets benchmarks outpaced U.S. equivalents. Coming out of the crisis, investors were tantalized by exponential GDP growth stories, talk of booming middle classes and increased adoption of technology, among other factors. Credible factors to be sure and while those and others have played, the benefit to stocks has been nearly non-existent.
From 2017 through 2022, the MSCI Emerging Markets Index outpaced the S&P 500 just once on annual basis – in 2017. That followed a rough post-crisis stretch for developing world economies following the global financial crisis. Said another way, for close to 15 years now, emerging markets stocks haven’t been worth advisors’ and clients’ trouble.
That puts asset allocators in a bind because there is merit in geographic diversification and there’s evidence pointing to recoveries by ex-US equities.
First, the EM Bad News
As is the case with every other asset class, there are pros and cons with emerging markets equities. Let’s get some of the bad news out of the way first. That includes volatility, which can be sourced by geopolitical events, financial contagion and any other scenario that can afflict developed market equities.
“The biggest risks in markets are unforeseeable. Black swan events are extremely rare but can instantaneously change how we perceive decades of performance,” notes Morningstar’s Bryan Armour. “Significant negative outcomes for investors are more common in emerging markets than developed ones. As a result, foreign governments play a large role in the success of emerging markets. Asset or company seizures and significant policy shifts are among the risks investors accept when they invest there.”
Point is, emerging markets are more volatile than domestic peers. For the 10 years ending 2022, the MSCI Emerging Markets Index sported average annualized volatility of 21% compared to 17.4% on the S&P 500. Alone, that’s not an alarming difference if the more volatile index can make up the difference in performance terms, but wasn’t the case. Over that decade, the emerging markets index rose just 3.8% while the S&P 500 more than tripled.
Another issue to consider – one many clients don’t think of – is intra-country complexities caused by various legal and political system. When an investor taps a broad domestic equity fund, political and legal risks usually aren’t primary concerns, but they should be when evaluating equivalent emerging markets options.
“These complications reduce market efficiency and create risk for investors. In theory, taking on these risks should be rewarded with higher returns for investors. But that won’t always be the case,” adds Armour.
Emerging Markets High Points
It’s not all doom-and-gloom regarding emerging markets equities. Some of the good news attractive valuations, superior rates of economic growth, favorable demographics, and, broadly speaking, higher dividend yields and opportunities for payout growth.
Those factors should not be diminished nor should the correlation/diversification benefits associated with this asset class.
“Emerging markets also tend to march to the beat of their own drum, at least more so than developed markets,” concludes Armour. “This gives them an advantage as a diversifier for portfolios heavy in U.S. and other developed-markets stocks. Thanks to the lower correlation, emerging markets’ stand-alone volatility has a muted impact on a global portfolio.”
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