More of the Same in Emerging Markets

“It’s deja vu all over again.” – Yogi Berra

Emerging markets are in turmoil once again as the price of oil and a rising dollar are causing major issues for a number of developing countries. Emerging markets go through periods of booms and busts on a regular basis, but it seems that investors forget about this every single time they crop up.

MSCI data on emerging market stocks goes back to 1988. Since then the annual returns on EM stocks is 11.5% while the S&P 500 has returned 10.4% per year. But those EM returns have come at a cost of 60% more volatility in the monthly returns. You get higher highs and lower lows.

Just look at the rolling five year return figures for each market:

EM 5 yr vs SP500

The peaks and valleys in emerging markets are huge. The late-1990s and early 2000s saw negative double digit annual returns for quite some time.

From a diversification standpoint, this is actually a good thing. You don’t always want to see markets in lock-step with one another. But you can also see that emerging markets have much more variability from huge gains to crushing losses, even over a five year time frame. The current five year returns are less than 2% per year while the S&P 500 is up 15% a year.

Most people don’t realize that the U.S. itself was once an emerging market. From 1836 to 1928, the U.S. experienced a recession once every 2.1 years. Without the Great Depression, it’s unlikely the U.S. would have had such strong financial market returns in the ensuing 85 years. Unfortunately you have to break some eggs to make an omelette.

There will be winners and losers in the emerging market countries over time, but getting from here to there will see a number of boom-bust cycles. Get used to it.

Further Reading:
Putting Emerging Market Losses into Perspective
The Best & Worst Part About Investing in Emerging Markets

 

 

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  • Jim Haygood

    In their Global Investment Returns Yearbook 2010, Credit Suisse extended an S&P/IFCG emerging markets index back to 1975, using individual country histories.

    Their conclusion: ‘USD 100 invested at end-1975 in emerging markets became USD 2,215 by end-2009, an annualized return of 9.5%. The MSCI World [developed] index gave a terminal value of USD 3,037 and an annualized return of 10.6%. Thus, over the entire 34-year period, emerging markets slightly underperformed.’

    Maybe it’s not a coincidence that commodity-based emerging equity markets resemble commodities themselves. That is, long periods of boredom, punctuated by brief moments of wild euphoria and stark terror.

  • Ben

    That makes sense. But I think that many of these economies are going to become much more diversified in the fact that they’ll benefit more from a growing consumer class more so than commodities as they have in the past (Russia, not withstanding). But you’re right, the returns seem to come in short bursts. EM stocks are actually perfect for young people with a hefty risk tolerance because there are more opportunities to buy in at lower prices.

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  • Marc Gordon

    Regarding emerging market countries and “getting from here to there will see a number of boom-bust cycles. Get used to it” I chose to NOT “Get used to it.” Given (as noted in the first comment) that emerging markets do not outperform developed markets, but they do have stomach churning volatility, for most the better choice is to not invest there. I do not need that kind of drama in my portfolio!

    Also, there is very little empirical data to support the notion that developing economies which are experiencing rapid growth and industrialization have stock markets that experience rapid growth within a typical investor’s timeframe of perhaps a decade or two. It is more a “belief” than a fact, which is a dangerous investment thesis.

    Keep in mind that emerging markets have the following highly amplified risks versus the US stock market:
    1) Foreign Exchange Rate Risk
    2) Non-Normal Distribution (cannot be valuated using the same type of mean-variance analysis, corrections almost impossible to extrapolate)
    3) Lax Insider Trading Restrictions
    4) Less Liquidity (poor, slow, or expensive transaction costs)
    5) Difficulty Raising Capital (increasing the company’s weighted average cost of capital)
    6) Poor Corporate Governance System (and weak accounting standards and regulatory framework)
    7) Increased Chance of Bankruptcy (results in higher bond costs)
    8) Political Risk (eg. current poster boy Russia)

    I won’t go into detail on each, but suffice it to say that the small chance of outperformance combined with the high volatility does not justify taking these risks.

    All the best,
    Marc

    • Ben

      All valid points. I think my conclusion is that for EMs can work for someone in their very risky bucket, but for others there are simply too many risks (which is what you’re saying). Totally agree. It all depends on how much volatility and diversification someone is willing to handle. And I agree with you that the “invest where the growth is” was a terrible narrative that didn’t make any sense. Growth only matters if it’s translated into shareholder gains.

  • ASHIT KOTHI

    I would like to respond to the above discussion point by point.

    1) Foreign Exchange Rate Risk – This will be the case for US investment also once there is a Reserve Currency which will replace US $ as Reserve Currency.
    2) Non-Normal Distribution (cannot be valuated using the same type of mean-variance analysis, corrections almost impossible to extrapolate) – Nothing to comment
    3) Lax Insider Trading Restrictions – Check US Capital Market History and Corporate fraud on investing public. Yes US market is more sophisticated in everything.
    4) Less Liquidity (poor, slow, or expensive transaction costs) – For a investor who is investing long term – Return matters not transaction cost.
    5) Difficulty Raising Capital (increasing the company’s weighted average cost of capital) – When all other countries’s capital is channeled through tax-haven into developed world, cost of capital will always be higher for all developing economies.
    6) Poor Corporate Governance System (and weak accounting standards and regulatory framework) – Less said then better for US track record.
    7) Increased Chance of Bankruptcy (results in higher bond costs) – Bankruptcy is a part of Business – some business flourish some fail. It matters most when bankruptcy laws are used to shield oneself.
    8) Political Risk (eg. current poster boy Russia) – What if US was banned for attacking other countries in the name of self defense. ?

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