Emerging Markets Dilemma

Why do I own International emerging markets stocks in in my portfolio? They are down 15% this year while the US market is up? Why don’t we just sell them?

We have received these types of questions numerous times over the past few months. We believe it is important to maintain a position in emerging markets both now and permanently. We discuss why in this WJ Notes.

Emerging markets are typically countries or regions that are in the process of rapid growth and development. They have lower per capita incomes and less mature capital markets than developed countries such as the US or Europe. These countries typically include China, Brazil, India, Russia, Mexico and so on.

Although these countries tend to be younger in their development, they also experience much faster growth than their developed counterparts. For example, China and India’s recent real GDP growth was 6.6% and 7.3% respectively, while the US only grew by 2.9% year over year. Thus, we own them permanently because we expect returns to be better than more developed markets and sometimes they will outperform more developed markets.

Why would we want to own them now? The following charts breaks down the roughly 30-year performance between 1988-2018 into four sub periods that reflect different market cycles.

As you can see, emerging markets (MSCI EM) and US Stocks (SP500) seem to have a somewhat cyclical relationship. Although they both end up with similar returns at the end, they have very different paths getting there. The chart below reflects the same phenomenon with a different look.

Each bar is a 5-year period. As you can see, the light blue bars (EM) tend to be doing well when the dark blue bars (US) struggle, and vice-versa. Although both investments are risky independently, they offset each other’s risk when blended together. This is called diversification and it has a desirable effect when used in practice.

For example, if you were to invest 80% of your money in the SP500 and the remaining 20% in EM during this period, your portfolio would have earned 11.34% annualized, higher than what either market made individually (10.2% and 11% respectively). How does this happen? It turns out that when you combine 2 or more unique investments (low correlation to be technical), you get a portfolio that is greater than the sum of its parts. Hence, the old but true cliché that diversification is the only free lunch in investing.

It is as difficult for us as it is for clients to hold onto investments that bring us pain in the short-term. It is at these moments that we must remind ourselves why we bought the investment in the first place and stick to our discipline. If you would like to discuss your portfolio, please contact us.