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Expanding Our Horizons

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Recently, emerging-market investors have had a wild ride. First, the Mexican disaster not so long ago, and the subsequent “Tequila Effect” that flowed over into the other emerging markets. As soon as we recovered from that hangover, along comes the Asian Flu. This has not been much fun! So, given this recent experience, should investors consider emerging markets as a separate and desirable asset class?

One of the goals of asset allocation is to spread the investment risk as widely as possible. More little bets are better than fewer big bets. Diversification is your buddy.

As a general rule, a desirable asset class is one that has favorable risk/reward characteristics, and a low correlation to our other holdings. The acid test is what the inclusion of the asset class does to the overall risk/reward profile of the portfolio. On that basis, there is a strong case to be made for long-term investors to consider emerging markets.

Risk Happens – But So Does Reward

First, let’s just admit that emerging markets carry a lot of risk. Occasionally, risk happens! When it does, it can be painful indeed. Fortunately, investors can diversify some of this risk away. While markets are influenced by global events, they are driven primarily by local politics, economics, and policy. Each separate country or region is somewhat isolated from other emerging economies. What happens in Poland bears little relationship to events in Portugal, Peru, or the Philippines. Even countries sharing long borders may have low correlation to each other. The economies of Chile and Argentina, for example, have danced to different drummers for generations. Consequently, a well-diversified portfolio of emerging-market countries will have a far lower risk level than any single country might. Even so, there is still plenty of risk left.

Correlation of the S&P 500 and Emerging Markets

Correlation Correlation
Argentina 0.48 Philippines 0.26
China 0.31 Poland 0.17
India 0.14 South Africa 0.16
Korea 0.02 Thailand 0.36
Malaysia 0.29 Turkey 0.04
Mexico 0.35 Zimbabwe 0.03

5-year correlation (through 2-28-98) of the S&P 500 and various emerging markets based on change in stock index prices. A score of 1.00 would indicate perfect correlation with the S&P 500. Source: IFC

As we have previously noted, investors do not enjoy risk, so they will expect higher returns from risky asset classes. The good news is that there is strong economic reason to believe that they will receive above-average returns over time. No one would invest in emerging markets if that were not the case.

It shouldn’t come as a surprise that countries with high economic growth rates also have high stock market performance. As a rule of thumb, over reasonably long periods of time, for every percent of increase in a country-s Gross Domestic Product, its stock market will increase about three to four percent. In a developed country a 3.5% growth rate may be the highest sustainable. But many emerging markets are forecast to have growth rates of 6 to 10%. Given this strong historical relationship, it doesn’t take a math whiz to see the potential for superior stock market returns in an economy growing at that rate.

There’s a good argument to be made that today-s emerging markets present investors with historic opportunities. With the total collapse of communism, developing countries worldwide have embraced capitalism and economic reform with a vengeance. Suddenly, Lesser-Developed Countries (LDCs) are doing everything right:

  • Protective tariffs are falling, opening up markets to meaningful competition.
  • Socialistic policies are giving way to free labor markets.
  • Extension of the rule of law is attracting international capital.
  • Stock markets are being modernized and/or formed, and opened to foreign investors.
  • Capital is being freed to flow across international boundaries.
  • Dictatorships and despots are giving way to elected governments.
  • Deregulation and privatization are the order of the day.
  • Serious efforts are being made to control inflation and discipline government spending.

This abrupt about-face has created conditions for sustained economic growth in countries that had previously sabotaged themselves. With better economic policies and fundamentals, confidence in the emerging economies should increase. It isn’t unreasonable to hope for both higher growth and increasing stock valuations in emerging markets.
The Going Gets Tough

Most emerging markets are reasonably small, and by comparison not as liquid as what we are used to in developed countries. Therefore, large cash flows into or out of such markets will drive prices rather smartly. International investors are notoriously fickle, so the markets can be whipsawed faster and further than local conditions may deserve.

Here are a few other things to keep in mind when investing in emerging markets:

Trading costs are higher in emerging markets.

Higher costs mean that active managers will have to be “right” much more often to overcome the drag of their own activity. For this reason, I am on balance convinced that index funds are a viable vehicle in these markets.

Mutual fund coverage of the very small markets is pretty sparse.

Most funds concentrate their investments in the “almost developed” countries. For instance, there are only a handful of funds with any African or Middle East exposure. While there are obvious difficulties (liquidity, cost, and selection) in these very small markets, their rates of return could be substantially higher.

Expect to see overlap when comparing holdings in emerging-market funds.

While fund managers would like to have you think that they tromp through the jungle with their pith helmets and waders while searching out undiscovered values for investors, the portfolios actually have a dreary sameness. After you have bought the local telephone, power company, brewery and cement plant, pickings in some countries may get a little slim. (I hope someday to see an emerging-market fund that doesn’t hold Siam Cement!) The largest differences between the funds in both portfolio and performance are due to their country weightings.

Best for the Long Haul

The bottom line on emerging markets is that despite all the recent turmoil, a small allocation to emerging markets (10 to 15% of your equities) is prudent for long term investors. We can reasonably expect that including emerging markets will help us to obtain higher returns while controlling risk at the portfolio level. It goes without saying, however, that investors must maintain a very long view, exercise discipline, and be prepared for the occasional gut-wrenching volatility.