Until mid-2011, emerging-market stocks were a prime destination for investors who wanted a high-risk/high-return option, or who simply wanted to add beta to their portfolios. More recently, however, emerging markets have been a source of consistent underperformance and extremely poor risk-adjusted returns.
Is this just a pause, or the beginning of a new, longer-term trend?
A brief look back at history provides some insight regarding where we are today.
At the approximate start of the financial crisis on Sept. 30, 2007, the Vanguard Emerging Markets Stock Index Fund (VEIEX) had a 10-year average annual total return of 12.5% — nearly double the 6.5% annual return of Vanguard S&P 500 Stock Index Fund (VFINX). Investors were taking on more risk by investing in the emerging markets, but at least they were being paid.
Since the crisis, during which emerging markets stocks lagged sharply, the tables have turned. From Oct. 1, 2007 through the present, VFINX has an average annual gain of 3.9%, while VEIEX has averaged a loss of 2.4% — a swing of $3,816 on every $10,000 invested.
Drilling down even further, the emerging markets have been left in the dust in the past two years. While VFINX has logged a cumulative gain of 56.9% since the end of September 2011, VEIEX has gained just 14.4%.
The returns alone are bad enough, but emerging markets also have been more than half-again as volatile as U.S. stocks in the past five years. This means emerging-market investors are accepting substantially higher risk for much lower returns — the very definition of a poor investment.
Not only that, but the shortfall in the past two years — in a generally “risk-on” environment — means the asset class isn’t even fulfilling its role as a high-beta trading vehicle.
How Long Can This Go On?
With numbers like these, investors might be tempted to establish a position to capitalize on a possible mean reversion. At some point, that might be a good idea considering the asset class continues to feature a number of attractive (albeit well-known) attributes: strong fiscal management, a growing middle class and better growth relative to the developed markets, to name three.
But for now, the key issues that have pressured performance of late all remain very much in play. Among them are:
- The rising dollar: The PowerShares DB US Dollar Index Bullish Fund (UUP), which has a large negative correlation to emerging-market stocks, has gained 2.1% in the past six months.
- Falling commodity prices: Emerging markets have a high correlation to commodity prices due to their above-average dependence on natural-resources exports. Year-to-date, PowerShares DB Commodity Index Tracking Fund (DBC) has fallen roughly 7%.
- Quantitative easing fears: Historically, emerging markets have been sensitive to developed-market monetary policy, so the prospect of “tapering” has pressured performance.
- Potential stagflation: At the same time as economic growth is slowing, some key central banks — most notably, Brazil — are being forced to hike rates to head off inflation and protect their currencies.
- BRIC underperformance: Broad, index-based products have had a hard time making headway due to the weakness in the BRICs. On a year-to-date basis, China, Brazil and Russia have all lagged the emerging markets’ headline return, making it difficult for funds such as Vanguard FTSE Emerging Markets ETF (VWO) — which has a weighting of nearly 40% in the three countries — from making much headway.
- China: While fears about a hard landing in the world’s most important economy continue to wax and wane, the potential for a destructive slowdown — with the attendant ripple effects across the emerging markets — remains a key obstacle preventing capital from returning to the asset class.
What Should Investors Do?
This litany of woe argues for a wait-and-see approach right now. The iShares MSCI Emerging Markets ETF (EEM) chart is exhibiting the potential for a multiyear head-and-shoulder top with a neckline at roughly $35 — about 12% from current prices. While this might seem like a substantial cushion, keep in mind that the EEM declined 17.2% just in the interval from May 8 to June 24.
With the potential for negative headlines to disrupt performance, the proximate nature of this key technical level indicates that the risks continue to outweigh the rewards in the short term. There’s no doubt that if one or more of the issues mentioned above — most notably China — surprises to the upside, investors will miss out on some gains by waiting.
At this point, however, the adverse risk-reward profile indicates that investors who are looking to play a mean reversion should exercise patience.
Finally, keep in mind that December has traditionally been the best month for the emerging markets in recent years. According to equityclock.com, EEM has averaged a gain of 4.4% in December from 2004-12 (versus an average return of 1.2% in all other months), with gains occurring in seven of nine calendar years. This might be a clue that if a break below the neckline takes EEM down into the low $30s sometime in the autumn, longer-term investors should jump on the opportunity.
Until then, caution remains the order of the day.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.