Why I’m Not Crazy About Emerging Markets

by Mike Holman

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Emerging markets are supposed to be the ‘hot’ markets, the place where the adventurous can get more return for more risk which is a tenet of many investment books including Four Pillars of Investing.

I’ve noticed that there are quite a few funds particularly Latin American funds which are extremely volatile but don’t necessarily have “better” long term returns although they have very good recent returns.

I decided to try doing some extremely unscientific research on emerging market mutual funds, using GlobeFund.com – “emerging market funds” category.

When I did the query on the emerging market funds, there were 71 funds available. I sorted by 10 year returns to get all the funds that have been around for at least 10 years which does not include funds which no longer exist but should be counted in the study (survivorship bias).

I got the “since inception” return – this is not all that scientific since the dates are not the same but the idea is that if people bought at the beginning of the fund – that’s the long term return they would have. I took all these funds which have been around 10+ years and put the data on a spreadsheet. This group seems to be mostly Latin American funds.

I removed all the duplicates (ie US$ versions, different classes) and calculated the average return from inception which came out to 6.3%, if we add 2.75% mer that gives us approximately a 9.05% gross return.

Given the extreme ups and downs of this group – the returns don’t seem to match the risk whether you bought the index or a retail mutual fund. By way of comparison the TSX total return for the last 10 years is 10.33% and 15 yrs is 11.88% which is not only higher but with less volatility.  MSCI Europe (Cdn$) was 8.93% for 10 years and 11.78% for 15 yrs.  *S&P 500 Composite Total Return Idx($Cdn) was 5.56% for 10 years and 10.41% for 15 years.

Of course with emerging markets doing so well over the last 4 to 5 years it seems silly to worry about the long term returns but for someone who is thinking about starting an emerging market position now, they should be very cautious.

Are emerging markets worth their volatility? These markets are much more volatile than developed markets so if they don’t outperform over the long term then you are better off sticking with developed markets.

I’m still planning to have a portion of my equity in emerging markets but I plan to err on the side of caution and will go a bit underweight in this sector.

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{ 10 comments… read them below or add one }

1 TheFinancialBlogger

I definitely have a good point. I would add that when a category of fund or stock is becoming to “hot”, it is the time to sell and let it go.
I have the impression that most of small investors don’t know much about the volatility and risk within this category of funds. They just invest money in it as they heard some good thing about it from their neighbor or read an article in the last weekend newspaper.
Cheers,
FB.

2 FourPillars

I couldn’t agree more.

There was a study of US stock returns by Ibbotson looking at returns from 1925 to 1991 or so and they concluded that small cap stocks had higher volatility and higher returns than large cap stocks. It seems logical but I’m not sure if that’s always the case.

Mike

3 Canadian Capitalist

I am holding off on getting exposure to emerging markets as well. The asset class does not offer enough of a return to justify the risks at current prices.

Remember last spring? Emerging markets tanked 25% (they’ve since recovered and gone higher) but how many markets routinely lose a quarter of the value in a matter of weeks? I always find it ironic that investors worry about a falling US dollar but not about the huge risks in these equities.

4 ThickenMyWallet

My largest issue with emerging markets is financial transparency. In some markets there is none so the market is not sure whether the financials being reported are accurate are not.

I always believe the safer way to play emerging markets is to buy domestic companies that have large foreign holdings- at least you know what you are getting.

5 FourPillars

Good point Thicken, however it’s tough to measure how much exposure you have to emerging markets through domestic companies. Fact is, if you have exposure to Canadian commodity producers then you probably have a lot more exposure to China & other emerging markets than you might want. There are probably a lot more examples of that sort of thing.

6 FourPillars

Thicken – now you’ve got me nervous. I’m wondering if there is any point to having any direct exposure to emerging markets since if you are indexed in Canadian, US, European & Asian markets, you already have quite a bit of exposure?

7 Canadian Capitalist

FP: I think you should eventually have market weight exposure to emerging markets because of two reasons: (1) these markets provide returns commensurate with the risk taken (not enough of a history to make this claim, but looks to be true so far) (2) Correlation (though increasing) is not perfect with developed markets, so exposure provides valuable diversification benefits.

TMW is right. There are extra risks in these markets: corruption, political stability etc. are other risks, but if you get a wide enough exposure through VWO/EEM, the returns are high enough to justify the risk. These markets are so volatile that it is easy to wait: sooner or later, there will be a sale worth waiting for :)

8 Canadian Capitalist

On an unrelated note, I clicked trading goddess website through the link on the main page (from my office). Big mistake. Very nice pictures, but could get me into trouble at work :)

9 FourPillars

Haha…that site is for late at night after the kids have gone to bed.

10 ThickenMyWallet

Some large blue chip companies now divide out sales by geography so you can see how much exposure they have in the emerging markets. I believe (and don’t quote me on this) that GE now has more revenue from outside NA than inside NA.

I’ll write a blog soon about China and why I am deadly afraid to invest there. But CC is right that if you spread your risk geographically, your downside risk will be minimized from the structural issues of investing in emerging markets.

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