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Emerging Markets: A Useful Fiction?

They don't act as a group, but that may not matter.

Gregg Wolper, 11/20/2012

Do emerging markets actually exist?

It goes without saying that some countries are less developed than others, in that they have much lower standards of living and more widespread health concerns than the most "advanced" countries. But the phrase “emerging markets” is generally used in an investment sense and is not referring to overall development, which is a different matter. (For example, certain Persian Gulf states are wealthy by most economic measures, but with few publicly traded companies and limited trading volume, they qualify as emerging markets in a stock-market sense.)

Even viewed in that way, though, it seems obvious that the emerging-markets concept still has meaning. After all, whatever the deficiencies of the United States and major European countries, some other markets have notably weaker stock-market regulation, more-limited protection of shareholders’ interests and rights, and smaller trading volumes. On the bright side, these countries typically have faster economic growth rates than their “developed” counterparts.

However, in order to qualify as a coherent entity for investment purposes, emerging markets should generally have similar performance. One can’t expect identical returns, of course, but if the returns of some countries in a group are flat while some jump and others fall, all in the same year, then it’s hard to see why one would lump them together for anything but a white paper comparing the effectiveness of national regulators or some such purpose. For that reason, I argued in April 2008 that the emerging-markets concept had limited value. At that time, the markets in China and India were plunging, while others ostensibly in the same group, such as Taiwan and Brazil, had either small losses or were posting gains.

Stark Differences in Performance
That period's wide discrepancies in returns, which echoed China’s vast underperformance of other emerging markets in 2004 and most of 2005, lent weight to the argument that investors were better off dismissing the idea that emerging markets were a homogenous group in terms of their performance potential. It still made sense to invest in some companies in emerging markets, of course, but more selectively, by allowing the manager of a broad foreign fund to insert specific stocks into the portfolio whenever he found them to be worthwhile selections. (One advantage of such an approach would be that investors would no longer have to worry what the proper emerging-markets weighting is and whether their portfolio matched that figure.)

This year’s returns provide further support for that idea. One doesn’t have to use obscure markets for evidence, either. India’s market has soared roughly 18% so far this year, and Mexico is up about the same amount. But Brazil’s market is actually in negative territory, showing a dismal 8.5% loss. Russia is down 2.5%. (A key reason for Brazil's slide is a growth rate that has slowed to a level much lower than investors expect from an emerging market.)

Smaller markets also show wide variations: The Philippines is up a remarkable 35% this year, but Indonesia’s gain is a more muted 6% and the Czech Republic is 1.4% in the red. (All figures are for the MSCI standard index for each country, in U.S. dollars, through Nov. 16, 2012.)

If one can’t even provide a meaningful answer to the question “How is the emerging-markets group doing this year?” without endless qualifications and explanations, then the concept does not seem to be very useful.

Gregg Wolper is an editorial director and senior mutual-fund analyst at Morningstar.

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