When an investment is down-and-out, it’s always tempting to take a contrarian stance and play for a big rebound.
That may be the case with emerging market stocks right now, since the group has been pounded in the second half of this year.
But don’t be fooled: The fundamentals in the emerging markets are as challenging as ever, and the time to buy into broad-based funds such as Vanguard FTSE Emerging Markets ETF (VWO) or iShares MSCI Emerging Markets ETF (EEM) isn’t yet upon us.
Fundamentals Remain Bleak
The primary case against the emerging markets is that all of the factors that have weighed on performance in the past year are still very much in play.
Global growth continues to slow, and China’s economy is still far from the point of regaining steam despite the government’s efforts to stimulate the economy. Just last week, China released data showing that industrial production growth had reached a six-month low — indicating that October’s weak gross domestic product report was no fluke.
The emerging markets also continue to face the intertwined challenges of U.S. dollar strength and the possibility of interest rate hikes by the U.S. Federal Reserve. What’s more, commodity prices can’t find a bottom, hammering the many export-dependent economies in Latin America.
The asset class also remains under pressure from the continued deterioration in Brazil, where the government has been forced to raise interest rates to defend its currency even as growth has stalled. Current estimates are calling for a contraction of 3.1% in Brazil’s economy this year, along with inflation of approximately 10%. This is a key issue for broad-based, index-tracking emerging market exchange-traded funds, where Brazil is a top country weighting.
The most important consideration is that none of these trends look set to change, and there is little in the way of a catalyst to bring about a shift in the current environment. An investor who attempts to make a contrarian play in emerging market funds is essentially betting that global growth will recover, boosting commodity prices and papering over the structural issues in the troubled emerging economies.
For now, the risks of that proposition clearly outweigh the potential rewards.
Low Valuations Do Not Signal Opportunity
The unfavorable risk-reward profile is compounded by valuations. The downturn in emerging market stocks may seem to indicate that valuations have declined in kind, but that’s not entirely true. In fact, earnings estimates have been falling so quickly that valuations are still playing catch-up on the downside.
With that said, the emerging markets are still trading at a discount to the developed world: As of Oct. 31, the MSCI Emerging Markets Index (PDF) had a forward price-to-earnings ratio of 11 vs. 17 for the MSCI USA Index (PDF).
This sounds like an opportunity at first. After all, low P/E ratios are a good starting point for total returns, right? Not necessarily.
This chart from Henderson Global Investors (PDF) shows that the emerging markets have been trading at a discount to the developed markets for years. This puts the valuation argument on shaky ground, and it becomes even more problematic when the slowing growth in many emerging markets is taken into account.
As long as the emerging world is slowing faster than the developing countries, it’s unlikely that this valuation gap can close.
Value-Added Strategies: Higher Costs, Questionable Results
An investor who is thinking of moving into a broad-based emerging markets ETF has plenty of options that would appear to be lower-risk than either EEM, VWO or the third-largest fund in the category, Core MSCI Emerging Markets ETF (IEMG).
A number of companies offer emerging markets funds that pursue low-volatility, high-dividend or smart-beta strategies. In all cases, investors should likely expect to see a performance advantage in a down market. For many of these funds, however, that hasn’t been true.
The table below shows the year-to-date returns for the ten largest funds in the three categories noted above. While some funds have performed well in the down market, half have lagged the 11.8% loss of VWO.
The lesson: Paying higher fees for value-added strategies is a hit-or-miss proposition when it comes to bottom-line performance.
Active Management Has Been a Disaster
Active management also isn’t the answer. Right now, a common narrative in the mutual fund industry is that differences in fundamentals among the various countries in the emerging markets will lead to a divergence in returns. Unsurprisingly, the fund companies cite this as a reason why active management can produce market-beating returns.
Not so fast. According to Standard & Poor’s SPIVA U.S. Scorecard — a publication that measures actively-managed mutual funds against their benchmarks — a full 74% of funds have trailed the passive benchmark in the five-year period ended June 30, 2015, while 92% have lagged in the ten-year period.
Clearly, active management has hurt more than it’s helped.
An Unfavorable Trade-Off of Risk and Return
Emerging markets funds may offer a tempting target for investors who are planning their year-end portfolio reallocations. The asset class has underperformed significantly this year, and many investors may remember the massive returns of the 2003-2007 era and be looking for history to repeat itself. But that was a different time, highlighted by an upswing in commodities and stellar growth in the emerging markets.
This time around, fundamentals remain much weaker and the key issues weighing on performance in the past year are still very much in play.
As long as this unfavorable risk-reward equation remains in place, investors should approach the emerging markets with extreme caution.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.