By Richard Phillips, Chief Investment Officer and Kevin Muir, CFA, Market Strategist, for EastWest Investment Management, and republished here with permission
The trauma of the Great Financial Crisis of 2008 emanated from the United States, intensified in the United States, and ultimately caused the most pain in the financial markets of the United States. It resulted in American equities being heavily discounted on quantitative measures to levels not seen in many years. The undeniable economic distress spurred the U.S. government and American business to take far more dramatic action than their global peers to alleviate the pressure.
When combined with a severely discounted starting price and the most aggressive pro-business policy responses, the returns for investors in American equities over the past decade have been nothing short of spectacular. The idea of buying the best-of-the-best has only magnified the returns, as investors who have flocked into American equities in droves following the recent tax cuts have driven valuations even higher.
However, while chasing the hottest performing market might be a strategy that sometimes encourages investor confidence in the moment, sound investing is not an exercise where following the herd is necessarily rewarded in the long run.
In the following article, we discuss why Emerging Markets can be an important component of a well-constructed portfolio in all environments, but also highlight why, on a tactical basis, the current setup offers an attractive entry point for the more dynamic investor.
Emerging Markets portfolio allocation for the long-term investor
In 1952, a young PhD. Economics graduate studying at the University of Chicago under notable heavyweights such as Milton Friedman (the original “Monetarist”) and Jacob Marshak (the father of Econometrics), put forward a new idea that would forever change portfolio management. Published by the Journal of Finance, Harry Markowitz’s “Portfolio Selection” paper introduced the concept that investors could create an “efficient frontier” of optimal portfolios, offering maximum expected return for a given level of risk. Modern Portfolio Theory (“MPT”) was created from the idea that examining the expected return and volatility for each security or asset class was not sufficient, but that by combining these metrics the optimal portfolio mix could be found which, with the benefit of diversification, would have a more attractive risk-reward profile.
Although MPT was born almost seventy years ago, it’s a lesson forgotten by many investors all too often as they “performance chase” the current hot stock, theme or asset class.
Given the U.S. stock market’s spectacular performance during the past decade, it would be natural to assume that there would be little reason why an investor should want to have owned any Emerging Markets exposure (or any other country’s stock market index for that matter). However, when constructing a portfolio for the long-run, it is important to understand the benefits of diversification offered by investing in a mix of different indices.
We will examine the long-run returns of owning only U.S. stocks (S&P 500 index) and then also combining them with a weighting of the Emerging Markets index (MSCI).
Over the past three decades, Emerging Markets have had periods where they have underperformed U.S. stocks, and other times when they shot the lights out. Since 1988, an investor that was solely invested in American stocks would have returned 1500%, while the 100% Emerging Markets portfolio was up only 1250%.
Although it might seem like Emerging Markets were a poor choice when compared to U.S. stocks, if we think back to Markowitz’s theories it still makes sense to consider whether Emerging Markets can play an important role in portfolio creation.
What if we examined the returns of the solely American portfolio at one extreme versus the 100% Emerging Markets portfolio at the other extreme, and then looked at both the returns and the volatility of different portfolio compositions in between.
Although at first blush the highest return is the 100% American portfolio, that isn’t telling the whole story.
Another Markowitz contemporary, William Sharpe created the famous ratio which bears his name. The Sharpe Ratio measures the average return of a security or asset class per unit of volatility.
If you think about two asset classes – one which returns on average 20% but carries annualized volatility of 100% with a second one which returns 15% but has limited volatility of only 10%, it is clear the second asset is more attractive, but before Sharpe’s Ratio it was difficult to quantify.
However, with the advent of the Sharpe Ratio we can measure the relative return per unit of risk.
Looking at the table of returns and Sharpe Ratios of various U.S. index and Emerging Markets index combinations, it becomes clear that being solely invested in American assets is not the optimal portfolio set.
The reason for the higher Sharpe Ratios in certain combinations? When you add Emerging Markets to the U.S. index, it decreases the overall volatility of the portfolio. The “Mean Vol” column for the 100% S&P 500 portfolio in the table above shows that an investor experienced a 15.60% annualized volatility. Yet when the portfolio consisted of 50%/50% S&P 500 and Emerging Markets, that volatility was lowered to 13.42%.
As we add more EM to the portfolio, the total volatility declines until we hit a 50%/50% asset mix.
But the really interesting part of this exercise? The 50%/50% portfolio actually returned more than the 100% S&P 500 portfolio even though the 100% Emerging Market portfolio returned less than the S&P 500. How can this be? If you add a lower performing asset, shouldn’t it result in a lower total return? It should, except that in our example we rebalance the portfolio monthly to maintain the desired relative weights. The forced discipline of buying the lower performing asset and selling the higher performing one creates a whole that is greater than the sum of its parts.
A portfolio including 40% or 50% of the Emerging Markets index has less volatility and a higher return, and therefore a significantly higher Sharpe Ratio.
Emerging Market equities play an important role in the construction of a well diversified portfolio. Their less correlated returns reduce the total volatility of the portfolio, while not sacrificing any gains.
It is almost a free lunch – something that rarely occurs in the world of finance, and when those words get uttered, one should always question the logic because all too often, there is a catch.
So, let’s spell out that catch. It’s difficult investing for the long haul to begin with. It’s tougher owning Emerging Markets when U.S. stocks are rocketing higher. And it’s downright demoralizing owning an asset class that has been underperforming for years while your friends are shooting the barn doors off with their FANG trading.
But as that famed investor from another era, Bernard Baruch was fond of saying, “the main purpose of the stock market is to make fools of as many men as possible”.
Humans are designed to seek confirmation in others. So as sure as night follows day, the same mistakes are made over and over again. It can be challenging to stick with the diversification strategy.
For the individual with the discipline to ignore the tendency to follow the pack, large opportunities can sometimes present themselves.
Tactical Emerging Markets call for the more aggressive investor
In the late 1990’s, while developed markets were in the midst of the DotCom bubble, Emerging Markets traded at deep discounts to their more industrialized counterparts. This made sense: many of these Emerging Markets were still coming into their own with respect to corporate governance and shareholder rights.
However, as the century turned over and more best practices were incorporated, investors became more comfortable with Emerging Markets. When this was combined with China’s admission into the World Trade Organization (WTO) and other global initiatives that bootstrapped Emerging Market economies with increasingly global free trade, it became clear that the real engine of growth lay in these emerging economies, and investors started to pay up for that growth.
From 2001 to 2008 (the year in which the Great Financial Crisis hit), returns from Emerging Markets soared relative to developed markets.
Yet a peculiar thing happened in 2011. That relative outperformance turned into underperformance.
Let’s turn to the fundamentals.
Despite the ups and downs in price performance, the Price/Earnings ratio of the S&P 500 has for the most part been consistently higher than that of Emerging Markets.
Further, the spread between P/E ratios of the two indices has hit a thirteen year new high: the S&P 500 Index is the most expensive versus the MSCI Emerging Markets Index since 2005.
And how about book value?
When we compare the two indices on this basis, the trend becomes even more clear.
The S&P 500 was awfully expensive to Emerging Markets on a book basis in the 1990s (which made sense given the nascent state of the Emerging Markets status), but during the next decade the spread was almost entirely closed. Yet during the past eight years it has once again blown out to levels where S&P 500 stocks trade at twice the price of Emerging Markets stocks on a price to book basis. Does this make sense?
There are a variety of reasons put forward by investors as to why this is the case. Over-borrowing in U.S. dollars is often cited as the main culprit. A turn towards more socialistic economic policies is also sometimes mentioned.
However, when one considers the demographic forces, decreasing underemployment and technological dissemination impacting countries outside of the traditional industrialized economies, it’s challenging to see how Emerging Markets will not outpace developed markets in terms of growth, even with the current challenges to the international trading order. Further, even if one were not to accept this hypothesis, we have noted that we are trading at recent “wides” in the valuation gap between industrialized and Emerging Markets. Finally, as the analysis above has shown, we don’t even need a narrowing in the valuation gap for there to be compelling reasons to include the diversifying benefit of Emerging Markets in a portfolio.
Regardless of one’s view about Emerging Markets’ prospects, there can be no denying that Emerging Markets are on sale, with their low absolute P/E and P/B metrics. Taking a longer term view, this valuation is not something to fret about, but rather something which may be worth taking advantage of.
We will leave you with a quote from Warren Buffett’s 1987 letter to shareholders where he expounded on the famous Ben Graham allegory about Mr. Market’s manic behaviour:
Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions, he will name a very low price, since he is terrified that you will unload your interest on him.
Ask yourself what kind of mood Mr. Market is in when it comes to Emerging Market stocks. With the diversification benefits these equities can provide, it certainly looks to us like he is overly depressed.