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Emerging Markets Fight Back To Prove Their Worth To Investors

by Paul

The appeal of emerging markets, the hugely diverse equities markets of high growth Asian, Latin American and African economies, has long been predicated on them offering investors higher returns at the cost of increased volatility and low correlation to developed markets. However, as they have matured, it has sometimes seemed as though those qualities were fading.

Returns and volatility have moved closer to those typical of developed markets, as has their correlation as international finance becomes more intertwined. It has raised the question of their continued strategic importance within diversified portfolios. A recent Wall Street journal analysis directly posed the question whether it isn’t time to phase out the broad investment class of ‘emerging markets’ entirely.

The diversity of the equities markets grouped together in emerging markets indices, among which the MSCI benchmark dominates, was the crux of the argument. The column asked if it made sense to group relatively developed equities markets such as those of South Korea and Taiwan alongside those of much poorer nations such as India and South Africa. Last year’s introduction of Chinese A shares, listed on mainland exchanges rather than in Hong Kong, further muddied the waters.

However, new analysis comes to the conclusion that the emerging markets asset class still has a valuable role within investment portfolios. One of the issues with emerging markets is that serious analysis is made difficult back much poorer historical data. But the latest Credit Suisse Global Investment Returns Yearbook, a 20 year-old annual analysis of international investment classes that mines data right the way back to 1900, has gone some way to rectifying that.

It focuses on emerging markets and their role within international investment. Data is still an issue with the first emerging markets index not established until 1985 when S&P released the first. However, the three academics responsible for the annual study, Elroy Dimson, Paul Marsh and Mike Staunton, all of London Business School, classified countries with GDP per capita of less than $25,000 adjusted to 2010 terms, with reliable markets data going back to 1900, as emerging markets.

This provided them with a seven country historical index covering China, Finland, Portugal, Spain, Russia, South Africa and Japan. The trio’s data cuts out constituents of their index at the year their economies developed to a point they no longer qualified under the below $25,000 GDP per capita cut-off. So Japanese data is only included until 1967, Spanish until 1974 and Finnish until 1932.

Other countries considered ‘developed’ earlier in the timeline but which became poorer after 1900 were included from the appropriate year. So India is included from 1953, Malaysia 1964, Brazil 1955 and so on. From 1985 onwards the data set reverts to the MSCI Emerging Markets index.

The analysis shows that over the entire period from 1900, emerging markets have actually performed worse than developed markets, with average annual returns of 7.2% to 8.2%. However, this is mainly down to markets in countries such as Japan and China being wiped out in the 1940s in the aftermath of the Second World War.

Since 1950, emerging markets have provided the stronger returns – 11.7% total average returns per annum to 10.5% for developed markets. The analysis further estimates that future EM returns will provide a 4.5% premium over Treasury bills compared to 3.5% for developed markets. Over the next 40-50 years the difference is expected to be around 0.5% in favour of emerging markets.

Even if investment risk is still higher for EMs, despite dropping over the last couple of decades, and correlation closer to DMs, the paper’s conclusion is that both the risk to reward ratio and level of correlation justifies an allocation to emerging markets to add diversity to a portfolio.

The biggest risk to that diversification is the gradual introduction of Chinese A-shares to the MSCI Emerging Markets index. Eventually that could take its total weighting towards China to 40%, significantly undermining the index’s diversification and potentially undermining its balancing value to portfolios.

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