Time to Rethink Emerging Markets?

At a financial planning conference in the mid- 1990s, I saw a top asset-allocation expert announce that her firm had recently made the decision to ignore bond-market returns before 1971, which is when President Nixon took the United States off the gold standard.

To her firm’s reasoning, that change inaugurated a new era of bond volatility, and the stable returns of the 1950s and 1960s could no longer be expected. The new reality for bond investors would be more like the tremendous volatility witnessed in the 1970s and 1980s.

This revelation, humorously 20 years after the fact, implied that any asset allocation derived from the now-discredited earlier numbers needed to be adjusted. But in a broader sense, it reminds us that the character of asset classes can change over time and that the lessons of the past may, at times, need to be adjusted. Sometimes the past is not prologue. Perhaps, such lessons apply to emerging markets today.

Twenty years ago, emerging-markets and small-cap stocks were very much intertwined in investors’ minds and with good reason. Portfolio managers spoke of the smaller, more focused companies they found in emerging markets and often praised the potential of these smaller companies to be acquired by global behemoths swooping in from more developed markets.

The numbers bolster this impression. In 1996,

Today, however, the situation is very different. The median market cap of the emerging-markets index now clocks in at close to $14 billion, and it no longer differs as greatly from the broader international index. In 1996, two thirds of the emerging-markets index placed in our small- and mid-cap buckets; today more than 80% of the index qualifies for our large- or giant-cap categories. That’s a dramatic shift. In terms of size, emerging markets are no longer synonymous with small-cap stocks. Today, they offer another shade of large, especially if you get your exposure to them through capitalization-weighted indexes, which naturally skew toward larger names.

Sector exposure has also changed considerably. It’s no longer just banks, beer, cement, and telephones that dominate emerging-markets portfolios. In the 1990s, these funds had dramatic overweightings in utilities, finance, and consumer durables and little to no exposure to technology and healthcare. It was a very different profile than the broader international markets, one prone to far greater cyclicality and different boom-and-bust patterns than the broader market. That’s likely one of the things that gave diversifying potential to the category.

Today, the picture is much different. Tech has gone from roughly 5% to around 20% of the average emerging-markets fund. Utilities exposure has fallen more in line with broader averages. Emerging markets now look more and more like the rest of the world, with the notable exception of much less healthcare exposure.

The maturation of emerging markets raises important questions for investors looking to diversify their portfolios. If these markets increasingly look like the rest of the world, they are likely to also act like the rest of the world. Do they really provide the same diversification benefit that they once did?

Moreover, as the world becomes more connected, it’s worth asking how much emerging-markets exposure you already have from exposure to global giants domiciled in more established regions. Several interesting studies have shown that the best way to play the rise of the United States when it was an emerging market was to own the British or French markets, which traded with the United States, rather than to have held the then-emerging U.S. stocks.

To be sure, there are other differences like currencies, but I think it’s worth asking how much of the excess return investors have expected from emerging markets came from their exposure to small-cap stocks? Perhaps, it was largely a small-cap premium that fueled the better expected returns. If this effect is dramatically less intact today, is it reasonable to expect better future results for courting the added risk of going outside developed markets?

Perhaps, one must move even further out the development curve to the frontier markets if one is to capture the benefits once promised by emerging-markets stocks. Maybe tomorrow’s asset-allocation experts will tell us, again likely 20 years after the fact, that the assumptions we have been using to build portfolios need again to be adjusted? If emerging markets no longer differ so greatly from the pack, are we fooling ourselves that we diversify portfolios through their inclusion? Perhaps, we are just layering more of what clients already own into their portfolios and creating a false sense of diversification.

This article originally appeared in the December 2016/January 2017 issue of Morningstar magazine.