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Emerging Markets: A Useful Fiction?

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

Gregg Wolper, 11/21/2012

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.

That said, I’m no longer as adamant about that fact as I was in 2008. The main reason is that logic doesn’t control investing and performance. People do. And people acting on their own thoughts can make something meaningful even if, on its face, it ought not to be.

Investors Make Themselves Heard
Regardless of country-by-country variations, the emerging-markets group does show a pattern that can’t be dismissed. Over the past three years through Nov. 16, the MSCI Emerging Markets Index has gained 2% on an annualized basis, while the MSCI EAFE Index of developed markets has lost 0.1%. The gap is even greater over the five-, seven-, and 10-year periods. Over the 10-year stretch, in fact, the emerging-markets benchmark more than doubled the EAFE Index’s return, 15.5% to 7.2%.

Emerging markets don’t always outperform their developed counterparts as a whole. The point is that their overall performance does often differ markedly from that of EAFE, and typically has outpaced that benchmark.

One reason is that a great many investors continue to treat emerging markets as a cohesive entity, even if the performance of the various individual markets this year seems to indicate otherwise. The billions of dollars invested in the most popular funds that target the group as a whole demonstrates that. (Vanguard Emerging Markets, which is both a mutual fund VEIEX and an ETF VWO, and iShares MSCI Emerging Markets EEM are among the largest funds in any category. The Vanguard fund has $55 billion in assets, while the iShares offering has $38 billion.) So does the considerable attention devoted to Vanguard’s decision to change the benchmark on its emerging-markets fund, among others, and BlackRock’s decision to open a new iShares emerging-markets ETF with a lower expense ratio without dropping the cost on its existing one.

In addition, when investors were acting on the unfortunately named “risk-on, risk-off” prompts earlier this year, one of the plays big investors made on supposed “risk-on” days was to shift money into emerging markets as a whole. And vice versa. They did not seem to be carefully differentiating among them.

Choices for Everyone
The result is a somewhat confusing situation, but one that can actually answer just about everyone’s needs.  

Because individual emerging markets don’t move in sync, (and because faster economic growth rates do not guarantee better stock-market returns), investors who like to keep things simple have every justification not to own a distinct emerging-markets fund, and to stop fretting about having the precisely correct exposure to emerging markets, whatever that number might be. They can own one or two broad international funds and let the manager make those decisions. Typical large-cap foreign funds tend to have about 10% of assets in emerging markets, but the amounts vary widely, and some devote 25% of assets or more to emerging markets.

Meanwhile, for those who do want targeted exposure to what has been a better-performing area for quite some time, and who believe there’s reason to continue lumping them together, the emerging-markets concept can still work. The ongoing pattern of many investors viewing them in that way increases the likelihood that owning an emerging-markets fund can pay off. As always, though, one should keep an eye on expenses and makes every effort not to get caught piling in after big rallies or taking money out at the bottom. 

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

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