Large U.S. stocks have notched a mostly stellar performance since their post-financial-crisis rebound, beginning in March 2009. However, the same can’t be said for emerging market stocks.
The Financial Times Stock Exchange emerging index has declined about 15 percent over the past five years. The index tracks large- and mid-capitalization stocks based in 21 emerging markets.
The largest emerging-market country weightings in the FTSE index includeChina, India, Taiwan, Brazil, Mexico and South Africa. The index also tracks countries in Eastern Europe and the Middle East.
A number of factors determine whether a market is considered developed or emerging. For example, emerging nations often have fewer financial-market checks and balances, relative to those in developed countries. Banking and regulatory systems often lag, and these nations may be politically and economically unstable, at least to some degree. That adds up to investors demanding a higher return for taking more risk than with Apple (AAPL), Exxon Mobil Corp. (XOM), Microsoft Corp. (MSFT), Johnson & Johnson (JNJ) or General Electric Co. (GE).
Most investors understand intellectually that risk and return are related. But should they continue holding an asset class, such as emerging-market equity, that is suffering a prolonged slump?
“I believe that long-term, growth-oriented investors should have emerging market exposure,” says Ryan Wibberley, CEO of CIC Wealth in Gaithersburg, Maryland. “As the more developed economies continue to mature, the growth rates from these places are most likely going to be lower than the rates found in some emerging economies.”
In a diversified portfolio, all asset classes generally don’t move in the same direction at the same time. That lack of correlation tends to smooth returns, but it also worries investors who don’t like seeing any of their holdings heading south, especially over several years.
However, financial advisers say it helps to keep long-term goals in mind when evaluating any particular asset class. From there, an investor can determine what is appropriate for his or her situation.
“An investor with a long horizon and high risk tolerance can hold a diversified group of emerging market ETFs that filters companies for attractive attributes, such as low volatility,” says Chuck Self, chief investment officer of iSectors, anexchange-traded fund strategist in Appleton, Wisconsin.
Self says retirees, who frequently opt for income-paying investments, may find that some emerging-market funds fit the bill. For example, he cites the WisdomTree Emerging Markets High Dividend Fund (DEM) as an ETF containing high-quality companies that pay high dividend yields.
Scott Kubie, chief investment strategist at CLS Investments in Omaha, Nebraska, says investors who turn their back on emerging markets may forego gains over time.
“Emerging markets represent a large and important part of the investment universe. A portfolio without any emerging-markets exposure would not have investments in China, Mexico or much of Eastern Europe. Investors who pass up potential opportunities in emerging markets will miss out on the opportunities in these markets,” he says.
Kubie says that even with the recent outperformance of U.S. stocks, emerging-market equities have a 15-year track record of outperforming the Standard & Poor’s 500 index (^GSPC).
While the S&P 500 experienced the so-called “lost decade” between 2000 and 2009, emerging-market stocks outperformed. For the past five years, that situation has essentially been reversed. Proponents of globally diversified portfolios say that’s exactly why investors should hold different types of assets at the same time.
Patience, however, is always key when trying to stick with a portfolio tailored to one’s objective and risk tolerance. Investors often tinker with allocations that don’t perform as well as they’d hoped or expected. However, attempts to stem losses often result in missed opportunity as an asset class begins rising again.
Owning emerging markets equities can provide high returns to investors who exercise patience.
“Owning emerging markets equities can provide high returns to investors who exercise patience,” Wibberley says. “These asset classes tend to move quickly, and timing them is very difficult. The advantage of holding these stocks during a downturn is that you no longer need to be a market timing expert — which I have yet to actually meet one of these people. You capture all of the downside and all of the upside, which can be great.”
Advisers suggest keeping a long-term perspective on the current emerging-market underperformance.
“Unfortunately, the recent downturn was prolonged by strong decreases in the Chinese growth rate. This has happened to various countries as they attempt to emerge,” Self says. He says similar issues occurred with other fast-growing Asian nations in the early 1990s, and with Russia in 1998.
“Eventually, these stock markets have come back and hit new highs,” he says. “Trying to the time the move in and out of emerging markets is tricky, because you have to be correct when you sell, and you have to get back in before the market runs up. Unless they are guided by a rigorous quantitative model, very few investors can make both calls correctly and consistently.”
Even professional investors with a tactical approach say emerging-market exposure is often worth the risk. It comes back to a basic buy-low-and-sell-high philosophy. While investors always like that idea in theory, it’s not necessarily easy, in practice, to buy a beaten-down asset class.
“Holding an asset through a downturn is never fun. The real challenge is knowing when to exit and when to re-enter asset classes. Most investors, we find, are slow to take advantage of opportunities and slow to exit them when they turn. CLS’s approach is adjust the allocation to emerging-market stocks up or down based on market condition,” Kubie says.
“Right now, our approach is to emphasize emerging-market stocks in the portfolio because of their attractive valuations,” he says. “Emerging markets are cheap compared to most markets, especially the expensive U.S. market.”