Emerging Markets: Did You Remember to Pack Your Free Lunch?

“They account for more than 70% of the world’s population (over five times that of developed markets), 46% of its land mass (twice that of developed markets), and 31% of its GDP (almost half that of developed markets). And, taken as a group, their real GDP growth has been much faster than in developed markets.” (Source: Adapted from Jacobs et al, “How Should Private Investors Diversify?”, Mannheim University 2009; GDP information is from Mitchell, Maddison and IMF; market capitalization data is from S&P, MSCI and FTSE; frontier markets are excluded)

The emerging elephant in the room is too big to ignore – but also too popular to hop atop without careful consideration. In the end, emerging market equities have a place at the heart of a diversified portfolio, but chasing a strong decade of performance from 2000 to 2010 and expecting a repeat is unrealistic (and downright dangerous).

While the first chart above shows a significant total-market portion of GDP belongs to emerging-market countries, the second illustrates its lack of representation in terms of global market cap – put simply: many of these markets are simply not as investable for one reason or another, but that does not mean they are as small as their world weights might indicate.

For an index investor, this is where things get really interesting: the average emerging market has had higher-than-developed returns over most periods in recent past decades … but with much higher volatility. However, emerging market indexes have had a mix of returns, higher or lower than the rest of the world, but with much lower volatility.

And this is where the free lunch comes in: adding just one percent of emerging markets to a developed-markets portfolio can itself reduce volatility by over one percent. A prudent investor (or at least: someone searching for a free lunch) can actually construct a less-risky portfolio by diversifying internationally and, specifically, by including some emerging market equities.

But no need to go overboard, either – for all we know, correlations may remain high (as they have been in recent years) going forward. Still, even at their record highs, there is a significant benefit to branching out beyond both home country and other developed markets that should not be overlooked.

So, while there is a free lunch in the form of diversification, investors need to be careful, too – this past decade saw a huge advantage for EM stocks and funds, but if risk and reward match up in the future, a more reasonable expectation would be a 1% to 1.5% bonus for adding EM (not a 5% to 10% one we have seen in the past ten years).

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