Emerging Markets Are For Real

In your blog this week, you stated the premise of emerging markets as being “higher returns but with higher risk.” It’s easy to understand why you think that, because there’s plenty of press behind that idea.

But really, the reason for investing in emerging markets has less to do with just juicing the beta of your portfolio and more to do with diversification. You highlighted Russia, Mexico and Ireland as examples of confusion—Ireland in trouble, paying fat coupons on their debt, Russia seemingly in the catbird seat and under control. You go on to call the division of companies into emerging and developed as lazy.

But being “developed” has never been some kind of imprimatur of profitable investing. Rather, being “developed” has to do with the nature of your underlying economy. Ireland may be in trouble, but its economy is unquestionably modern. Based on GDP measurements, it’s one of the wealthiest countries in the world, even in the midst of chaos. Its GDP is nearly 70 percent services-based, and just 6 percent agricultural. It has real markets, real regulations and a stable government in little danger of a military coup or outbreaks of totalitarian dictatorship.

Russia’s, by contrast, has less than half the GDP, and a history of instability, corruption and mis-regulation.

How do you say oligarch in Celtic? You don’t, and that’s the point.

That’s not to say one is good and one is bad, it simply means that their economies will be influenced by different factors. What makes one grow won’t necessarily make the other grow.

Let’s look at some of the numbers involved. First, are emerging markets providing any real diversification vs. developed markets? We’ll use the two most popular international indexes as our proxy: the MSCI EAFE (developed markets) and MSCI Emerging Markets indexes.

The chart above is the daily correlation between the MSCI EAFE and Emerging Markets indexes in dollars. On any given day, the two indexes are generally going to move in the same direction, with some notable exceptions. This is to be expected, and is absolutely nothing new. Correlations today are no worse than the near 1.0 average over the last decade.

Of course, emerging markets bets have been riskier. Here’s a chart of the same two indexes’ 30-day volatility over the last 10 year:

Both indexes have had periods of substantial volatility and, indeed, when the you-know-what really hits the fan, emerging markets do spike higher. But the day-to-day expectation of the two indexes is remarkably similar.

But none of these charts is what really drives investors. After all, most investors focus on performance.

The correlation here is easy to see, as is the spike in volatility, which drove emerging markets down hard during the financial crisis. However, they also recovered faster, more violently and to better effect.

Clearly the pattern of returns here is substantially different, and different is what investors are looking for. The 300 percent returns during the “lost decade” don’t hurt either—the S&P is up just 8 percent over this same time frame.

The premise of emerging markets isn’t lazy. Like all indexes, emerging markets indexes are simply a pooling shortcut, allowing investors to express an opinion without picking stocks. In this case, that opinion is “developed economies are mired with difficulties, less-developed economies are the place to be.”

And let’s be honest, those investors have been right.

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