What’s Wrong with Emerging Markets?

Written by John Osbon on March 9, 2011

While the US markets are up nicely since the beginning of the year, emerging markets are down. What’s going on?  After all, China, Brazil, and other developing economies have the enviable trade surpluses, high growth rates, and excess reserves that the US doesn’t. Are the new “bankers to the world” who have been funding our growth by buying US Treasuries stalling before our eyes?

Recent data looks grim for emerging markets. This three month chart shows the big lag between the largest emerging market ETF, Vanguard’s VWO, and the S&P 500.

Source: Yahoo Finance. Enlarge chart here

Many experts are trying to explain (or explain away) this performance gap. (See the Investors Business Daily article, “Why Are Emerging Market ETFs Lagging So Badly?”.) There are plenty of theories to go around, from inflation to rising interest rates. Depending on the theory one accepts, the chart above could be an urgent warning to sell or a clear signal to buy.

In my view, it’s neither. I don’t even think it’s the right chart to look at.

A longer view of VWO versus the S&P (below) shows that the current lag in emerging markets is just a little more squiggling in an already very jagged line. Over the last six years, emerging markets equities have behaved about as one might expect, with both higher long-term returns and greater volatility than large cap domestic stocks. VWO is up 84% since 2005, even with its dramatic crater in 2008-09, while the S&P is barely in positive territory for the period.

Source: Yahoo Finance. Enlarge chart here.

By the way, VWO is just one of many emerging market investments. For instance, iShare’s EEM, (which, like VWO tracks the MSCI EAFE index), traces a chart similar to VWO. And DGS from Wisdom Tree is a dividend-oriented small cap emerging markets ETF with a current yield of 2.5%.

Too big to ignore

Emerging markets matter. Up from a miniscule share a decade ago, they now comprise about 26% of global market capitalization, based on the 20+ nations that index-maker MSCI classifies as emerging. Some predict this share to double by 2030.

Based on this rapid and continuing growth, emerging markets deserve the attention of investors. But the size of an allocation to emerging markets, in my view, should be based not on short-term data, but on long-term expected risk and return characteristics.  Holding emerging markets means you are ready to accept a higher level of expected risk in exchange for a chance at higher returns, and can endure the sometimes frenetic headlines and commentary that accompany volatile returns.

As always, diversifying among many asset classes helps to reduce exposure to poor short-term performance in any particular market segment, like the recent lag seen in emerging markets.

So what’s wrong with emerging markets right now? Nothing, in my view.  They are behaving in the short term as one might expect, with prices changing like the March weather.

 


  • This communication may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.”
  • “Historical performance is not indicative of future results. The investment return will fluctuate with market conditions.
  • Past performance is not indicative of any specific investment or future results. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor.
  • Investment strategies, philosophies, allocations and holdings are subject to change without prior notice.
  • This communication is intended to provide general information only and should not be construed as an offer of specifically tailored individualized advice.
  • While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information.
  • Adviser does not endorse the statements, services or performance of any third-party vendor.
  • Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable.