Hot Topic: Emerging Markets

What emerging markets are on your radar, and what information are you considering or watching for before making an investment?

 

Rick Ferri

Rick Ferri:  Why try to pick single emerging countries when you can own them all in an emerging market index fund? Emerging market index funds owns thousands of stocks across dozens of countries and their performance beats most professionally-managed accounts. It’s your best way to gain instant diversification and earn your fair share of market returns.

It’s difficult to imagine that U.S. investors would have more information about what’s happening in South Africa or Turkey than investors who live there. It’s hard enough living in this country trying to figure out where the U.S. stock market is heading.

More than 75 percent of all professionally-managed mutual funds have not kept pace with the emerging market index over the past 5 years, according to S&P Indices Versus Active (SPIVA). If it’s this difficult for the pros to pick hot emerging counties, a regular person doing it has little hope for success. 

There are several low-fee emerging market index funds on the market. The major difference among the indexes they track is whether South Korea is considered an emerging market or a developed market. Most index providers place South Korea in the developed market category, but MSCI handles it differently. This leader in international equity indexes is keeping South Korea as an emerging country.

Why resort to hair-pulling and eye-rolling when trying to choose an emerging market fund when you can just buy the whole market? An emerging market index fund has diversification, low-cost, and the performance has beaten most of the pros.

 

Eric Nelson

Eric Nelson:  Out of the $38T invested in stocks around the world as of year-end 2012, 14% was in countries designated as “developing” or “emerging”.  For long-term investors who believe in holding globally diversified asset class portfolios, emerging markets stocks represent a core holding.  These 5 rules can ensure you get the most out of that allocation.

#1 – Investors who want the higher expected returns from emerging markets must be willing to put up with higher risk.  The oldest data we have on emerging markets goes back to 1988.  Through 2012, emerging markets stocks (MSCI Emerging Markets Index gross div.) earned +12.7% per year vs. +7.2% for developed market stocks (MSCI World Index gross div.).  However, that higher return came with almost double the volatility. 

#2 – Emerging markets allocations require extreme patience, as they can go extended periods with disappointing results.  For much of the late 1990s and early 2000s, emerging markets lagged behind developed markets by a significant margin.  From 1994-2000, while developed market stocks earned +12.8% per year, emerging markets actually lost 4.8%.  From 2011-2012, developed market stocks earned +5.2% per year, but emerging markets stocks lost -1.5%.

#3 – Emerging Markets are no place for active management.  Over the last 10 and 15 years respectively, the DFA Emerging Markets fund (DFEMX) has beaten 68% and 82% of surviving emerging markets managers through April 26th.  Yet the DFA fund makes no attempt to pick the best countries, sectors, stocks, or time the market.  This result against active management is even greater than we see in domestic or international developed markets.  And results would have been worse still if we added back in the 30% or 40% of emerging markets active managers who did so poorly over the last decade or more that their funds disappeared from mutual fund databases altogether (along with their poor returns).

#4 – Not all “passive” emerging markets portfolios are the same.  Vanguard is the expense ratio leader in emerging markets, as in most other asset classes.  But net of fee, expected returns matter more than expense ratios.  Alternatively, the DFA Emerging Markets fund keeps expense ratios relatively low while also focusing on a more balanced allocation across countries, and an emphasis on keeping turnover and buy/sell transaction costs to a minimum.  For this well-rounded effort, we see that DFAs Emerging Markets fund after expenses outperformed Vanguards Emerging Market Index Fund (VEIEX) by 0.4% per year over the last decade and 1% per year over the last 15 years through April 26th.

#5 – Large and small value emerging markets asset classes add higher expected returns and enhanced diversification.  From 1999 through March of 2013, the S&P 500 Index compounded at +3.6% per year with a standard deviation (risk) of 17.8.  If we added just 10% to the DFA Emerging Markets fund (DFEMX), our portfolio return jumped a full 1% to +4.6% per year, and standard deviation (risk) only went up to 18.4.  Over this same period, emerging markets value stocks outperformed the large cap growth-oriented DFA Emerging Markets fund by 3% per year, and came with about 20% higher volatility. But if we instead added the 10% from the S&P 500 Index to the DFA Emerging Markets Value fund (DFEVX), a more diversified mix of over 2,000 large and small value stocks, the portfolio return increased to +5.1% per year, but standard deviation (risk) only rose to 18.6.  Over this period, adding riskier emerging markets value stocks to our S&P 500 Index allocation didn’t materially raise total portfolio risk (standard deviation went up by 0.8) because of their diversification benefits.  Portfolio returns, however, increased by a meaningful 1.5% per year.

Source of Data: DFA 2013 Matrix Book, DFA Returns 2.0, Morningstar.com

Past performance is not a guarantee of future results.  The returns and other characteristics of the allocation mixes contained in this article are based on model/back-tested simulations to demonstrate broad economic principles.  They were achieved with the benefit of hindsight and do not represent actual investment performance. There are limitations inherent in model performance; it does not reflect trading in actual accounts and may not reflect the impact that economic and market factors may have had on an advisor’s decision-making if the advisor were managing actual client money. Model performance is hypothetical and is for illustrative purposes only. Model performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. Advisory fees and other expenses incurred in the management of portfolios would reduce client investment results.  Indexes are not available for direct investment.

 

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Richard (Rick) A. Ferri, CFA is the founder of Portfolio Solutions,  the low-fee investment management firm he founded in 1999, which currently manages more than $1 billion in assets.  He is the author of six investing-related books, and shares his insights as a frequent news commentator, Forbes columnist, media contributor and public speaker.  Rick holds a Master of Science degree in finance from Michigan’s Walsh College, where he has served as an adjunct professor. Prior to entering the financial industry, Rick served as a U.S. Marine Corps officer and fighter pilot before retiring from the reserves in 2001 with twenty years of service.

 

Eric Nelson is a CFA charterholder who has worked in the investment industry for 15 years.  He is the co-founder of Servo Wealth Management, an independent RIA in Oklahoma City, Oklahoma.  Eric has a passion for educating investors about how capital markets work and helping his clients achieve and maintain financial independence while “simplifying complexity”.   Outside of the office, Eric enjoys spending time with his family and their three dogs, he is an avid runner and a diehard Syracuse Orange college basketball and San Francisco 49ers NFL football fan.  Eric’s research and commentary on investing can be found on his website www.servowealth.com  at the “Servo Thoughts” blog and the “Factors in Focus” newsletter.

 

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