4 reasons why pulling out of emerging markets doesn’t make sense

Why pulling out of emerging markets borders on foolhardy

Historically, long-term demographic and economic trends have been the key motivations for investing in the emerging markets asset class. As populations grow in the developing world and shrink in the developed world, economic growth will be focused on the emerging markets. These trends are generally agreed upon and are compelling motivation for investors looking at the long term.

However, recent negative returns in these markets are causing many to ask why they should stay in the asset class “now,” showing little consideration of longer-term trends.

While the strongest arguments for investing in the emerging markets are based on long-term perspective, below are four additional arguments, explaining why an investor should stay in and, if not currently invested, why now may be an opportunity to add exposure.

1. VALUATIONS

Looking at any number of valuation metrics, it is clear that emerging market stocks are cheaper than developed market stocks.

When compared with their historical averages, we see that U.S. equities are at extended valuations, while both developed and emerging markets currently stand below their average measurements.

Based on those observations, most valuation-sensitive investors would find the emerging markets attractive on both an asset-class relative basis and an historical basis. The fact that many investors are considering selling emerging market assets to purchase U.S. equities is at odds with this data.

2. DOLLAR STRENGTH

A large part of the recent decline in emerging markets is due to the sharp rally in the U.S. dollar in the past two years. That is, equity markets in a foreign country’s base currency may have increased, but the depreciation of the foreign currency versus the dollar results in a loss. In the past three years, this has reduced emerging market returns more than 7% on an annualized basis.

While the future of currency markets is unknown, you shouldn’t assume such a rally will repeat itself. That is, recent experience is not a good representative of expectations for currency impacts.

3. DIVERSIFICATION

Emerging and frontier countries are not as integrated into the global economy as developed nations, due to the former possessing more internally focused economies and industries. This naturally leads to equity markets that exhibit low correlation to the equity markets of the developed world. The persistently lower level of correlation generally leads to an expected diversification benefit at the portfolio level, as portfolios with allocations to emerging markets can bring higher expected returns with lower expected volatility.

We view this as evidence that the asset class remains an effective diversifier, as the very nature of diversification is for an asset class to be down when others are up, despite our human tendency to want assets that both diversify and only go up.

4. UNDERWEIGHT

If one uses market capitalization as a frame of reference, then exclusion of emerging markets represents a 9.6% underweight from a neutral position (where MSCI ACWI’s allocation is considered to be neutral).

To exclude the emerging markets completely would be an extraordinary underweight, larger than excluding, for example, all of Japan and similar in size to removing both the U.K. and France. While these latter examples typically are seen as bordering on foolhardy, anyone considering eliminating emerging markets would be equally aggressive. It is rare to find a level of conviction that matches the magnitude of this bet.

CONCLUSION

Recent emerging markets performance has caused such a degree of fear that for many investors the strategic reasons for owning the asset class no longer seem compelling.

We have laid out four arguments to support staying: It is cheap versus its historical average and versus other asset classes; recent returns have been savaged by currency impacts that are unlikely to be repeated; it remains a powerful diversifier; and its elimination would represent a bet that is larger than the conviction of many making the bet.

To those who remain anxious or afraid, perhaps the most germane advice is to repeat Warren Buffett’s homily about when to buy: “Be fearful when others are greedy and greedy when others are fearful.”

Tim Atwill is head of investment strategy at Parametric. He can be reached at [email protected].