Unfortunately, the longer I practice as a portfolio manager, the more cynical I become regarding certain aspects of our business. The great push to include emerging markets funds in a ‘diversified’ portfolio has become my favorite annoyance lately. Granted there should be no doubt that I am reacting to the very poor performance of these funds lately, but this missive is about more than that.
In our industry, practitioners are taught that markets are efficient and diversification rules. I won’t go into the various problems with those theses – which are only that: theses, as they cannot be proven like the law of gravity is proven. Instead, we’ll lay groundwork by reminding readers that ‘diversification’ means including lots of different ‘asset classes’ in your portfolio to reduce risk. In the 1980s, policy wonks at a division of the World Bank came up with the idea of emerging markets. Later, Wall Street decided these constitute an asset class, and by the way, making these markets accessible to the average guy resulted in very high fees paid to these selfsame Wall Streeters. Industry academia jumped on the bandwagon, plotting ‘efficient frontiers’ including emerging markets funds, purportedly to show that a dollop of these investments added to a portfolio would reduce risk for only a small give-up in return.
The experience of the last few years must be disappointing to owners of these portfolios. In fact, the experience of the last ten years should be disappointing. Emerging markets funds as measured by Morningstar’s classification of rated funds have returned 1.95% per year over the last five years, versus 9% to 14% for the various categories of US stock funds. Using 10% as the return on US stocks (on the low side) and rounding up the emerging markets return of 1.95% to an even 2%, that’s a difference of almost $51,000 on a $100,000 investment over five years. Even diversified bond funds had a better showing at 3.28%. Over ten years, the MSCI Emerging Markets ETF (EEM) returned just 3.26% per year. Worse, the long term variation in return (standard deviation) of emerging markets funds has been 22%, versus just 16% for the S&P 500. If you want to severely dilute your return to seek lower risk, bonds are a better choice than the riskiest stocks on the planet.
Aside from the horrific returns and high risk in emerging markets, I take issue with the underlying intellectual reasons given for utilizing these investments. Here’s why:
- Better growth in emerging markets and a larger slice of world GDP does not lead to high stock market returns. Consistently, evidence shows that economic growth is only slightly correlated with stock market returns. And good growth overseas comes with strings attached, such as lower political stability, uncertain effectiveness of financial controls in a US dollar dominated world, and expanding choices for investments in these economies. In other words, as economies grow, they offer more investment opportunities, which in turn cannibalizes funds from existing opportunities, restraining returns on all public companies. William Bernstein pointed out in 2009 that markets in low growth, stable countries performed best over the last 20 years, partly because the public-company opportunity set could expand so rapidly.
- In my lifetime, not one ‘emerging market’ has ever emerged. Markets that remain underdeveloped for decades are not attractive prospects.
- The rule of law is deteriorating worldwide, not improving. Property rights are unique to developed markets. China has no property rights. Africa has limited to no property rights; ditto many countries in the Middle East. Where property rights do not exist, high quality collateral does not exist, hampering large scale entrepreneurship. In the US, many small business owners get started by pledging their homes as collateral for a loan to expand. That alchemy is much more difficult if you don’t own property.
- Judicial processes, such as bankruptcy, are extremely inefficient and take a long time, preventing reallocation of capital to better uses. This goes for some developed countries as well, by the way. Italy is a notable example.
- Related to number 1, the opportunity set of public companies in emerging markets is undiversified. Many traded stocks are financial companies or extractive industries such as mining or energy. Few are consumer related. There is no place to run for cover should the stock market in Malaysia falter – except getting out of Malaysia. We won’t even get into the various accounting rules that dictate how earnings and sales are reported overseas – suffice to say there can be shocking disparity versus American rules.
- In some significant percentage (which varies according to whose numbers you use), participating in emerging markets means being a minority owner alongside countries’ governments. Governments are poor economic stewards. They are not innovative, they can prevent efficient capital allocation, they can insist on rules such as labor laws that are not in the interest of shareholders. Sometimes they can simply appropriate your asset without payment.
- Wall Street pundits have taken to saying that emerging markets are now ‘cheap’ – after years of sluggish returns. But we see this differently: perhaps they are cheap because investors are beginning to understand that the knocks against these markets are significant and not improving, making the entire asset class worthy of avoiding. Perhaps in fact, emerging markets should always trade cheaply.
As an alternative, we prefer accessing emerging markets exposure by owning companies headquartered in North America that sell to emerging markets customers. These companies are better managed, and still benefit from growth overseas. And if that’s just not enough for you, you can create an imbedded portfolio tilt by seeking only US companies that generate significant earnings from emerging markets. You will end up with a well diversified portfolio at a reasonable level of risk.