If you're attracted to the relatively low stock valuations and top performance of emerging markets, a new white paper by Grantham, Mayo, Van Otterloo & Co. LLC warns that you should consider one other metric: risk.
Emerging markets funds have been on fire this year, rising 22.9% vs. 11.1% for the Standard & Poor's 500 stock index. And several prominent advisers – including Research Affiliates and GMO itself – have estimated that future inflation-adjusted returns of emerging markets should outstrip those of many developed markets.
However, in their paper "Revisiting the Traditional Emerging Market Equities Allocation Framework," GMO authors Amit Bhartia and Mehak Dua note that investors should combine valuation measures with risk assessments to improve their decisions on emerging markets asset allocation. Those risk assessments include macroeconomic vulnerability, currency and political factors. "Since 2002, an allocation to EM guided simply by Shiller P/E would have delivered robust median annualized returns of 14%," they write. "However, combining risk assessment tools with this simple valuation measure would have resulted in annualized returns of about 30% with fewer drawdowns over the same period."
The risk in emerging markets is considerable. The average emerging-market country's stock market has seen five times the drawdown of the Standard & Poor's 500 since 1990, Bhartia and Dua note. And, while the S&P 500 has fallen by 20% four times since then, emerging markets countries have fallen more than 20% "an astonishing 22 times," the authors write.
GMO recommends adding an aggregate risk index, using several variables for emerging markets countries:
• 1. Dependency on external savings to identify balance of payment risks
• 2. Above-trend growth to identify economies growing in an unsustainable manner
• 3. Currency valuation, because currency shocks translate into economic shocks and detract from returns for developed market-based investors
• 4. Political uncertainty to anticipate event risks. In many EM countries, the absence of economic institutions with long-standing track records of independence and effectiveness allows for the possibility of an individual in power to derail or severely impact economic growth.
The idea, of course, is to invest when valuations and risks are low. In the past, investing when emerging markets were expensive and high risk returned an average three-year return of 1.4%. Currently, GMO says, emerging markets are in the sweet spot: cheap and low-risk. The company currently estimates the seven-year real return for emerging markets at a 2.9% average annual rate for the next seven years, vs an average annual loss of 3.9% for U.S. large-company stocks.