How Much Emerging Market Investments Should We Own?
Key Takeaways
The rapid growth of the economies in our region often comes with the promise of higher-than-expected market returns, albeit with more risk.
Existing data challenges this assumption: from the period of 1990 to Feb 2023, stocks from Emerging and Developed Markets yielded similar returns. (6% p.a)
The relationship between a country’s economy and the performance of its stock market is not as strong or obvious as many may believe.
By investing through a scientific indexed approach, you can access and allocate these emerging countries in systematic and fuss-free manner without predictions or forecasts.
Diversification of risk matters not just defensively, but because it maximises returns as well, because we expose ourselves to all of the opportunities that there may be out there.
As investors based in Asia, we usually hear more and are more exposed to the “Asian Growth Story”. We tend to correlate the burgeoning economies and rapid rise of the countries in our region with higher-than-expected market returns. Although emerging markets represent a meaningful piece of the global investment opportunity set, we must keep in mind that they can be volatile and can lag developed markets at times. A proper globally diversified allocation will provide the right framework as a means to access these investments properly and safely.
Recent investment forecasts and outlooks urge investors to invest more into China due to optimism about China’s economy doing better following its sudden reopening after more than 2 years of COVID-19 induced lockdowns. Various strategies by wealth managers and financial institutions, like the following below from DBS, Goldman Sachs, and UBS, are advocating a higher allocation to Asian investments.
Lets look at some performance data
to see what it tells us.
Same Same, But Different
A look at a long-term returns of developed market stocks vs emerging market stocks from 1990 to Feb 2023 shows that there is practically no difference in terms of outcomes. Since there is inherently more risk when investing in emerging countries, why are so many investors enamored over it? Breaking down the performance into decades gives us a perspective.
You can see that the 2000s was the golden age of emerging market returns — likely driven by the rise of China; the Chinese economy from the early 90s to mid 2000s grew at 10% per year. It was the highest growth rate in the world and corresponded to a very stark emerging market outperformance.
However, in recent years the returns of emerging markets have lagged those of developed markets and by quite a large margin. There are many commentators who highlight that it is time for a reversal, but are we sure it will happen? There is no way to tell.
GDP & Market Performance, Related?
Investors also try to draw a relationship between a country’s economy and the performance of the stock market. This relationship however, is not a very strong one and one that is not quite obvious. The pie chart on the left shows where much of the global investible universe lies — the US forms around 60% of the stock market, with emerging making up around 13% only. However the right chart shows that in terms of economic output, the US is only one quarter of the world, and much smaller than the emerging economies combined.
So why isn’t there a higher weight, representation or performance from the emerging universe given that their economies are growing at a much higher pace?
For one, many people tend to overlook that many large companies in the world have global operations and as a result, global earnings. So a company listed in the US does not necessarily mean that it derives its earnings purely from the American market and is only exposed to that economy.
The diagram below shows that whilst US companies (represented by the S&P 500) still get the majority of their sales from their home market, their sources of income are quite varied from other parts of the world — tapping onto these external sources of growth. So investing in the US stock market could also mean some indirect exposure to emerging market growth without needing to purposely overweight those markets.
Navigating geopolitical events and potential market disruptions is still important when investing in emerging markets. Russia’s invasion of Ukraine in 2022 provides a stark example — with the Russian investment market currently frozen out to international investors.
The chart below shows that returns of individual emerging markets countries can be volatile and the dispersion across individual country returns can be wide. Substantial differences in returns can exist between the best-performing and worst-performing country. Are you able to tell ahead of time which country will do the best for the year? The best way to invest and at the same time mitigate the risk of unexpected events is through broad diversification and a flexible investment process.
So How?
So what is the best way to invest and allocate to these emerging countries? It is through a scientific indexed approach. When we allocate to a global stock market index, we adhere to the strict criteria that the creators of the index (such as MSCI, FTSE) use to determine how much of each company should be represented in an index. So as a company grows in terms of development, size, and access, so does its representation in an index.
So as emerging countries grow in importance on a global scale, so does their representation in an investment — and in our portfolios will also be represented likewise. For example, the chart below shows that just over 30 years ago, stocks listed in emerging countries only formed 1% of a global investment allocation. Fast forward to today, it forms around 12 to 14%. As some companies listed in China or India grow in size and importance in the future, so would their representation in your allocation. Who knows, perhaps emerging markets would form over 30% in an allocation in the next decade.
Investing in this manner ensures that you take the appropriate level of risks according to how a global market framework should look like. This also means that you don’t miss out when an up and coming country or company as you automatically allocate to it when the time is right. This means less predictions, forecasts and stress over where and what to invest in.
If you are unsure of how your investments are allocated, don’t know where or what to invest in or just need a second opinion, come and chat with us.
