Investors in emerging markets equities have had a rough ride for more than a year.
This asset class lost over 2% in 2013 - a year in which the S&P 500 gained over 32% - and they are not off to a good start in 2014.
As of mid-February 2014, the MSCI Emerging Markets Index was trading at a ratio of 11 times it’s earnings. That’s a 40 percent discount from the trading price of the MSCI World Index, which largely represents stocks from developed nations.
Their performance is even worse when viewed on a risk-adjusted basis, because emerging markets are a much more volatile asset class than U.S. large cap equities. Risk-hungry investors would have done far better by going into small-cap U.S. stocks in 2013 than into emerging markets.
But hindsight is 20/20. The real question is: How should investors handle emerging markets in 2014?
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Do you have emerging markets stocks in your portfolio? If so, then you may be wondering if it’s time to dump these losers and reposition back into other asset classes with a better recent performance history.
Of course, you may also be wondering just the opposite. With these stocks beaten down so far, are we facing a great buying opportunity - a chance to double down and cash in on a coming emerging markets rally?
Here’s our answer to both these questions: No, this not the time to dump emerging markets as an asset class in your portfolio. And no, this is also not the time to embark on a buying spree. Despite their recent underperformance, there are a number of reasons why this may not be the best time to bank on an emerging markets rally.
We will explain our thinking on both these points, below.
Why Shouldn’t I OverLoad My Portfolio with Cheap Emerging Markets?
If you’re thinking about increasing your exposure to emerging markets for tactical reasons, be aware of the potential risks that could work against you.
Emerging markets are synonymous with growth economies. For much of the 21st century, they have grown at a much faster clip than the economies of the developed world.
That pace has slackened off recently, though. Countries like Turkey and Brazil have seen GDP growth decline into the low single digits, while their currencies have fallen against the dollar and their external debts have soared.
Much of that growth they enjoyed for so many years was facilitated by borrowing. And much of that borrowing happened in hard currencies rather than their own local lira, real or rupiah. Those debts are coming back to haunt them.
The really big question in emerging markets, though, is China. Its impact on the world economy is immense, and it’s hard to imagine emerging markets as an asset class doing well in an environment where China is doing poorly.
The problem right now is that China is attempting to finesse a delicate move: to keep GDP growth humming along, while redistributing the composition of that growth to more domestic consumption. China is also trying to defuse a potentially dangerous credit bubble.
These aren’t new problems - they’ve been around for awhile - but they are not resolved problems, either. A negative shock from China could spark another negative performance cycle. This might affect all riskier asset classes, but emerging markets are likely to carry much of the brunt.
Emerging Markets Have Low Correlation
On the other hand, you shouldn’t flee from emerging markets, either. Emerging markets stocks play an important role in diversified, intelligently allocated portfolios.
Why? They tend to have relatively low levels of correlation with other equity asset classes. This helps smooth out volatility in your portfolio.
“Correlation” refers to whether or not two types of asset classes move in tandem with one another. Domestic equities and commodities, for example, tend to have “low correlation” -- whatever’s happening with stocks has little-to-no effect on what’s happening with commodities, and vice versa.
Likewise, emerging markets equities have low correlation with many other types of equities.
Sometimes that low correlation means that emerging markets underperform, as has been the case recently. But in other market cycles they have done very well, and over very long time horizons they have been shown to justify their higher volatility by outperforming less risky asset classes.
Moreover, emerging markets account for a large and growing share of the total global economic pie. China is the world’s second largest economy, and the Asia Pacific region in general is a dynamic center of international trade and capital.
As an investor, you should hold exposure to the asset classes that will capture a share of these important global capital flows.
Investing Is About Allocation, Not Market Timing
One of the most important contributors to your long-term investment performance is asset allocation. Not market timing, not stock selection, but asset allocation.
Numerous studies by academics and market pros alike have lauded the importance of asset allocation. This principle has stood the test of time. And a core tenet of this principle is that you hold asset classes in good times and bad, in pursuit of long-term returns.
In other words: Don’t over-focus on short-term market moves, including the performance of an asset class over the span of a year or two. Think about the long-term -- 15 or 20 years.
How Large of a Slice Should You Carve?
Smart asset allocation is about “slicing the pie.” Imagine that your entire portfolio -- managed across all of your accounts -- is one giant pie. (Or cake, if you prefer.) How large of a slice should emerging markets carry?
Your answer will depending on a number of personal factors, like your age, timeline, goals, and risk tolerance.
Emerging markets equities normally merit a smaller “slice” than other equities like U.S. large caps. That’s because emerging markets are a highly volatile asset class. A range of 5-10% of a total portfolio is not unusual for the emerging markets slice.
Investors with a reasonable emerging markets weight like this should be able to ride out the asset class’s down cycles without losing much sleep.
What Goes Down Comes Up … But When?
Investment assets demonstrate a remarkable degree of “mean reversion” over time. That’s another way of saying that at some point after an extended run of over-performance or underperformance, assets will tend to revert to average performance levels.
But it’s simple to say that emerging markets will rebound. It’s harder to say when that rebound might happen.
And that’s another reason why investors should neither dump all of their emerging markets stocks, nor load up on an oversupply. Instead, investors should maintain a reasonable “slice” of emerging markets in their portfolio.
If you are investing for the long-term and have emerging markets in your portfolio, be patient. Don’t give in to either fear or greed. Diversification pays off in the end.
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