If you own an emerging markets fund such as iShares MSCI Emerging Markets ETF (EEM) or Vanguard FTSE Emerging Markets ETF (VWO), it’s time to ask yourself a pretty important question.
By almost any measure, stocks in emerging markets represent an ineffective source of diversification for long-term investors.
And this isn’t a timing call based on the weak recent performance of emerging markets. Instead, it involves the broader issue of what constitutes the kind of diversification that helps you, as opposed to the kind that helps the fund companies.
The Illusion of Diversification
It’s a well-known fact within fund firms that the more of a company’s funds someone owns, the less likely the investor is to pull out all his or her cash and go elsewhere. In other words, encouraging you to diversify among numerous funds is a critical element of the fund companies’ business model.
The upshot is that we’re constantly being told to spread our cash across multiple asset classes, but without regard to whether the specific investments truly provide any diversification.
On this front, emerging markets are Exhibit A.
We’ve all seen the ads and promotional pieces put together by fund marketing departments regarding favorable demographics, stronger consumption trends and the tendency for U.S.-based investors to have portfolios biased toward domestic equities. While these points might be true on their own merits, they ignore the fact that stocks in emerging markets tend to be highly correlated to the performance of developed-market equities over time. The magnitude of returns might diverge, but the direction tends to be the same … which means there’s little in the way of actual diversification benefit.
Consider this: From its inception in 2003 through the end of 2012, EEM had a correlation of 0.8 with the SPDR S&P 500 ETF (SPY). Correlations run on a scale from -1.0 (two assets that move in perfectly opposite directions) to 1.0 (two that move in tandem). A correlation of 0.8 therefore indicates that two investments that are tracking each other very closely.
The correlation has dropped in the 14 months since the end of 2012, but only because the emerging markets underperformed U.S. equities by such a wide margin in that time — not the kind of diversification investors are looking for.
High Risk, Low Return
This highlights another issue with the asset class: The crisis/recession of 2007-08 put an end to the high-growth phase for emerging markets. From its April 2003 inception through its peak in Oct. 31, 2007, EEM surged 412% — nearly five times the 87% return for the SPY in the same stretch. Since that date, though, EEM has produced a cumulative return of -19.9%, compared with a gain of 36.1% for the SPY.
Unfortunately, there’s still more to the story.
Stocks in emerging markets have continued to exhibit higher volatility than domestic equities even as they’ve provided much lower returns. As a result, emerging markets aren’t the high-risk/high-return asset class that the fund companies’ marketing materials would indicate.
Instead, they’re a high-risk/low-return proposition that in fact has torpedoed investors’ attempt to diversify for more than five years running.
Managing Your Exposures
An equally important case for not holding a core position in emerging markets is that the asset class has increasingly become a single-country bet on China. Not only do the country’s fortunes affect those of its regional neighbors, but its role as the incremental source of demand for commodities means that it has become an increasingly important driver of performance for Latin American stocks with each passing year. With China still the vulnerable to a credit crisis, investors should question whether this is the exposure that they truly need to have in their portfolios.
Finally, holding funds that invest in U.S. or developed-market equities already provides a backdoor allocation to the emerging-market economies since so many large-cap companies are broad multinationals that already have a significant EM component to their revenues.
Emerging markets still can play a role for certain types of investors. Traders who are looking for ways to generate outperformance can usually finds some beta in the asset class when the markets are coming out of a crisis or a meaningful downturn.
From a longer-term standpoint, however, emerging-market stock funds have become an increasingly poor source of diversification for individual investors — a trend that doesn’t look set to change in the near future.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.