How much should you allocate of your retirement portfolio to emerging market equities?
It’s a timely question, since many widely-followed Wall Street firms are telling their clients that emerging market stocks are the only equity category whose expected return over the next decade is above inflation. Perhaps the most prominent of such firms is GMO, the Boston-based investment firm co-founded by Jeremy Grantham. It is projecting that the emerging market equity category will beat inflation over the next seven years by 5.0% annualized. In contrast, the firm is forecasting a 6.2% annualized loss to inflation over the same period for the S&P 500
As is also widely known, however, GMO has been making similar forecasts for many years now, and at least so far has been very wrong. Over the trailing 10 years, according to FactSet, the iShares MSCI Emerging Markets ETF
has produced a 3.4% annualized return, almost 10 annualized percentage points below the 13.3% annualized return of the SPDR S&P 500
Fortunately for our purposes, Credit Suisse has just released the latest edition of its Global Investment Returns Yearbook, authored by finance professors Elroy Dimson, Paul Marsh, and Mike Staunton. This yearbook arguably is the most comprehensive database of global returns, as it reports performance since 1900 for “equities, bonds, cash, currencies and factors in 23 countries.” For the first time, furthermore, this year’s yearbook was “broadened to include 90 developed markets and emerging markets.”
This long-term perspective is especially crucial when assessing emerging markets. That’s because we can all too easily forget that many emerging stock markets disappeared altogether at various points since 1900 due to “major events such as revolutions, wars and crises.” Their losses need to be taken into account when judging emerging markets’ prospects, and this Yearbook does.
This long-term perspective is crucial for another reason as well: Some emerging markets over the last 121 years have performed so spectacularly that they graduated to the “developed” category. Index providers employ a complicated methodology for determining when that graduation takes place and, as you can imagine, a lot is riding on that determination. But the inevitable result is that some of these emerging markets’ spectacular performance gets credited to developed market benchmarks rather than to emerging market indices. This yearbook’s authors employ an elaborate methodology to place each market each year in the appropriate categories.
You may say you don’t care how a country’s stock market is classified, just so long as it performs well. But you should care. If you invest in emerging market equity index funds, you at least implicitly are relying on the decisions that index providers make about what counts as an emerging market. There’s no way around it.
Without further ado, let me turn to what the Credit Suisse Yearbook reports. Over the last 121 years, emerging market equities have produced a 6.8% annualized return to a US-dollar investor, 1.6 percentage points below that of developed markets’ 8.4% annualized. I note in passing that developed market bonds beat emerging market bonds over this period by a similar magnitude: 4.9% annualized versus 2.7%. These returns are plotted in the accompanying chart.
These long-term returns suggest that the last decade’s results are not as unusual as they may otherwise seem.
Do these results mean that there’s no need to allocate any of your retirement portfolios to emerging market equities? Not necessarily. Part of the rationale for investing in them derives from their potential diversification benefits: If they zig while developed market equities zag, and vice versa, then a portfolio that invests in both would incur significantly lower volatility, or risk, than one that invests in developed market equities alone. This in turn could translate to superior risk-adjusted performance even if emerging market equities underperform.
The yearbook’s authors find that emerging market equities do provide some diversification benefit. However, that benefit has been declining over the last several decades, as correlations between their returns and those of developed markets have been rising.
The bottom line? I came away from this latest edition of the Credit Suisse Yearbook with diminished long-term expectations for emerging market equities.
That doesn’t mean we should automatically avoid them. But we should base any decision to invest in them on other factors besides their long-term returns.
GMO and the other firms advocating for emerging market equities do just that, by the way, basing their bullishness on valuation considerations. They believe that emerging market stocks are very cheap, according to any of number of valuation metrics, both in their own right and relative to developed market (and especially U.S.) stocks.
GMO and similar firms may very well be right, of course. But the 121-year record suggests that they will have to be very right indeed to overcome emerging market equities’ long-term tendency to lag developed market equities.