Many investors avoid emerging markets stocks due to recent underperformance in contrast with the U.S. markets. However, this could be a mistake. With human tendency to view recent events and project them into the future, you might come to regret a lack of emerging markets exposure.
Emerging markets are countries with faster-growing economies in less-developed corners of the world. Citizens of emerging markets typically have lower per-capita income than those in developed economies. The popular MSCI Emerging Markets Index includes 26 countries from Asia, North America, South America, Europe and Africa. Some of the larger countries included are Brazil, Russia, India and China, frequently known as BRIC.
During the previous 10 years, the emerging markets sector returns have substantially underperformed those of the S&P 500. From Nov. 13, 2010 through Nov. 13, 2020, the S&P 500 returned 200% while the MSCI Emerging Markets Index, as represented by iShares MSCI ACWI ETF (NASDAQ:ACWI), grew just 96%. During the past five years, the S&P 500 rewarded investors with a 68% return while emerging markets investors garnered just 49%.
With these disparities, investors might be tempted to skip an emerging markets stock allocation in favor of U.S. companies. However, this could be a mistake. The GMO 7-Year Asset Class Forecast of October 2020 predicts that emerging value stocks will be the best-performing sector during the coming seven years. The research suggests an 8.7% annualized return, besting all other asset classes by wide margins.
Big Companies Tend to Grow Slower Than Small Firms
Consider what drives investment prices over the long term. It is predominantly expanding corporate profits. To be included in the S&P 500, a company must have a market capitalization of at least $8.2 billion.
For example, the 25th largest company in the index, AT&T (NYSE:T) had net income of $13.9 billion in 2019. To grow the net income 10% would mean that the firm requires an increase in annual net income of $1.4 billion. That is a large annual increase in revenue for any company to achieve. That’s why you rarely find exceptional growth rates for the largest firms.
This is one reason to allocate a portion of your resources to emerging markets stock. These less-developed countries have yet to experience the consumption levels seen in developed countries. When they do, the opportunities for corporate growth are much greater.
At present, these markets account for 59% of the global gross domestic product (GDP). As emerging markets’ GDP continues to grow, it’s predicted that developed economies’ GDP will become a smaller percent of the world economy.
Trends that favor emerging markets include the fact that approximately 87% of the world’s population live in developing nations. Add a rapidly growing middle class, and investors might find that increasing incomes will translate into growing consumption and corporate profits for companies located in the emerging market regions.
Many in these markets are just beginning to embrace technology that has been commonplace in other parts of the world. This is another major growth driver for these regions. In fact, several of the most innovative companies like Samsung (OTCMKTS:SSNLF), TSMC and Tencent (OTCMKTS:TCEHY) hail from these countries.
How to Invest in Emerging Markets
There are many ways to capture this potential, from picking individual stocks, to investing in ETFs and mutual funds that cater to specific countries, sectors, regions and industries. Investors can choose index-based emerging markets funds or buy an actively managed fund.
Due to the preponderance of state-run entities, it may be more profitable to hire a manager who is familiar with the regions and offers an actively managed fund.
The Schwab Intelligent Portfolios robo advisor offers low and fee-free investment management with access to two emerging markets funds. With a nod to factor investing, this digitally managed portfolio invests 7% in the Schwab Fundamental Emerging Markets Large Company Index ETF (NYSEARCA:FNDE) and 3% in the Schwab Emerging Markets Equity ETF (NYSEARCA:SCHE) in their moderate 60% stock, 40% fixed-income allocation.
Sector expert Kevin T. Carter founded the Emerging Markets Internet and Ecommerce ETF (NYSEARCA:EMQQ). This rules-based, actively managed sector fund seeks publicly traded companies deriving more than 50% of their revenue from internet or e-commerce firms in emerging or frontier markets. The firms must have a market capitalization of at least $300 million and at least $1 million in average daily volume to be included in the fund.
For broad exposure, the Vanguard FTSE Emerging Markets ETF (NYSEARCA:VWO) is a low-fee option. With a 0.1% expense ratio and 2.76% dividend yield, this broad choice closely matches its benchmark. Importantly, it has also delivered a 10.43% one-year return.
The Bottom Line
So what is the bottom line? With an uncertain future due to the novel coronavirus pandemic, diversification is more important than ever. No one knows what the markets hold for the future. Home country bias will ensure that you will miss out. Why? Well, the U.S. makes up roughly 54% of the global stock markets.
Tapping the developing markets will allow you to capture the growth of the nascent countries, poised to consume and move up in socioeconomic status.
On the date of publication, Barbara Friedberg held long positions in VWO, FNDE and SCHE.
Barbara A. Friedberg, MBA, MS is a veteran portfolio manager, expert investor, and former university finance instructor. She is editor/author of Personal Finance; An Encyclopedia of Modern Money Management and two additional money books. She is CEO of Robo-Advisor Pros.com, a robo-advisor review and information website. Additionally, Friedberg is publisher of the well-regarded investment website Barbara Friedberg Personal Finance.com. Follow her on twitter @barbfriedberg and @roboadvisorpros.