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By Christine Benz | 10-13-2011 12:32 PM

Stay Diversified in Emerging Markets

No matter how fast one specific country is growing, or how cheap its valuation looks, investors are typically better off holding a broad basket of emerging-market stocks, says Vanguard's Chris Philips.

Christine Benz: I'm Christine Benz for Morningstar.com.

I recently interviewed Christopher Philips, who is a senior investment analyst in Vanguard's Investment Strategy Group. One of the topics we discussed was whether investors are better off investing in a broadly diversified emerging-markets fund or opting for single-country emerging-markets funds.

So, Chris, you have recently done some very timely research into a category of investments that's been very hot over the past several years: emerging markets. There has been a lot of interest in investing in specific emerging markets. You have done some research that looks at the benefits and the drawbacks of doing that. Let's take a look at some of your findings.

Christopher Philips: Absolutely. So, the big thing we hear now is that, "I want to focus on China as an investment because their economy is growing so strongly. We know that they hold a bunch of U.S. debt, and there is this whole trade issue between the U.S. and China. So, I want to really focus my investment on emerging markets, but I really want to concentrate on China as a core investment."

Benz: ... Or India or whatever it might be ...

Philips: Or India, or really any emerging market out there. Latin America is another great example because of a potential relationship to commodities.

So, what we attempted to do was really show that focusing on any specific country comes with a lot more risk than benefit, and it's a little bit more synonymous with investing in a single stock. So, a single stock, you certainly have return expectations, but you have potential wild swings in volatility which can be very detrimental to the risk-adjusted returns that you get in a portfolio.

So, we went through and we did some analysis around the risk and return trade-offs, the linkages between economic growth and market returns, the idea that I can play the dollar in some type of currency bet. So, we looked at a bunch of different views for evaluating the role of single countries.

Benz: So I would like to highlight that research that you and the team here have done on whether market performance follows from economic growth. I think it's a little bit counterintuitive, but what you found is that there isn't a particularly close correlation?

Philips: Yes, and I think the counterintuitive nature is the best way to sum it up. When you think of the rationale for investing in emerging markets, it's that I want to be able to capture that long-term expected high economic output, the high economic growth...

Benz: ... Of a China or India or whatever it might be.

Philips: Exactly, of any of the high-growth countries out there. And when you think very broadly, it makes perfect sense that as an economy performs, corporate profits will be linked to that economy, and therefore the stock market should ultimately be linked to that economy.

Well, with emerging markets, and actually with developed markets as well, what we've seen is that it tends to actually breakdown in terms of correlation, so that you have, say, the U.S. that has economic performance that is in line with that of the U.K., and yet market performance has been vastly different. So, you get this dynamic where, by investing in a China that you expect 10% growth, you don't actually get the benefits from that because you don't get paid for expectations that come true, and it is the same with earnings. So, if I invest in a company that has earnings expectations of 10% growth, and they achieve that, well, that expectation is already baked into the prices. So, you're not being paid for stuff that's already being baked into prices. You need to be able to predict outperformance, outsized growth going forward. And if something is already expected to grow 10%, then you have to expect it to grow 15% or 20%, and that's just extremely difficult to do.

Benz: Right. In terms of something that actually does tend to predict market performance, valuation, you did not find that even by focusing on those countries that appear to be trading at very low valuations--so if someone is conscious of prices and opts to get in, then--you didn't find that that was necessarily predictive of good market performance in single emerging markets either?

Philips: Yep, and that's actually one of the most counterintuitive aspects here, because we all hear that valuations are the single most important metric for future performance, particularly in equities. Then when you get to broad market equities, it's even more important. The challenge with emerging-market countries is that there are so much country-specific risk, and in the analysis, we actually used an example of, say, Venezuela, where Venezuela, before the market was shutout to private investors, had a P/E ratio of around six to eight times earnings, broad earnings across all Venezuelan companies.

So, if you saw that and relative to its history and relative to global markets, Venezuela would have looked like a tremendously attractive investment; however, if you invested and then all of a sudden you got shutout, you would have had a negative 100% return. So, the idiosyncratic or country-specific risk completely overwhelms valuations, especially in emerging markets.

Benz: So, the broad takeaway from all this research, if you can't really trust low valuations to guide you to the right markets or you can't trust growth prospects to guide you to the right markets, it sounds like you would argue that you are better off buying a broad basket of emerging markets rather than trying to bet on single countries.

Philips: Absolutely, and just using the valuations example--while they don't work in individual specific countries, they actually do work when you start aggregating them up into the broad emerging-market space. So, looking at aggregate valuation, we can say, effectively, that if emerging markets have a reasonable valuation, then we should expect some returns going forward. So, we think a lot of this does work in the broad space, just not in very specific targeted spaces.

Benz: Okay. Thank you, Chris. This is very useful research, and I think really timely.

Philips: Very welcome.

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