A Look Back At 20 Years of Emerging Markets

We are frequently asked about emerging markets — are they a good opportunity? — are they a dangerous investment? — how much should be allocated to them?

YES, they are a good opportunity, based on past long-term gains and expected future growth.

YES, they are a potentially dangerous investment, depending on how you define danger; particularly if you get queasy with high volatility and the potential for a long and steep drawdown.

It's not possible to say how much you should allocate to them without an individual analysis. What other classes do you have? How much do you have in each other class? What is your volatility tolerance? How long can you wait to recover from a potential period of decline? Can you sleep at night if things go badly for a while? What is your age, income and liquid net worth? What are your financial needs and obligations?

The Opportunity and Risk:

The best place to begin is at the beginning which we arbitrarily define as 1987 for practical purposes.

We would be remiss, however, not to note that the real beginning for emerging market stocks was actually 1602 with the formation of the Dutch East Indian Company (Holland) where the first stock market was created in 1606. Not long after in the early 1700’s, the Mississippi Company (France) and the South Sea Company (England) were sold to investors, also historic emerging market investments that made and lost investor fortunes.

Some important observations come out of that ancient history of emerging market stocks. First, they tend to create great interest and huge gains. Second, they can produce excess enthusiasm with subsequent periods of great losses. Third, some emerging markets make it beyond that stage to become developed markets — what is now the United States was once an emerging market, for example.

Emerging markets and public investors have been an investment phenomenon for about 400 years and are still a phenomenon today.

We define 1987 as the beginning here, because that is where our MSCI Barra data ends, and it’s also generally within the modern world economic timeframe.

The Last 20 Years:

The emerging markets from 1987 through 2007 handily outperformed the world markets, world market excluding the US and the US markets, as the chart below shows.

• Emerging markets proxies: (EEM) and (VWO)
• US market proxies: (VTI) and (IWV)
• World excluding US market proxy: (VEU)

$1 invested in emerging markets on December 31, 1987 would have been worth $10.89 as of December 31, 2007. The same $1 would have grown to $5.69 invested in the US market, and only to $3.01 if invested in the entire world excluding the US.

Major Drawdown:

However, as the chart also shows, there was a long and deep drawdown from May 1996 through August 1998 (28 months) that reduced the value of emerging market stocks by 52.2%. That was probably enough to drive most emerging market investors to sell at a loss, before the emerging markets resumed their decline — and they probably didn’t get back in early for the subsequent rise if at all.

The US market has not been immune to major drawdowns in recent times either. There was a major draw down in the past 20 years, for example. Between March 2000 and September 2002 (30 months), the total US market declined 48%.

Two Emerging Markets Rising Periods on Each Side of Drawdown:

The first leg up brought a $1 investment at the end of 1987 to about $5 over 101 months. The second leg up after the gut wrenching drawdown brought a new $1 investment in September of 1998 to about $4.50 over 113 months.

It has been a long roller coaster ride that has paid off well. For those too new to investing to remember time before 1998, it seems like on long ride up and up and up, until 2008 when emerging markets are down about 8% - 9% YTD as of mid-February.

The Abyss Between Point A and Point B:

It’s not just the long drawdown from 1996 through 1998 that most investors must worry about. People can look at monthly historical charts such as the one above and make various assumptions about their ability to withstand the heat or to know when to get in and out — but could they really?

Life is full of wonderful ultimate opportunities, that present a deep crevasse between where you are and where you want to be. That may be true of exploring the Antarctic or funding a project with huge potential but early choking negative cash flows. Emerging markets pose a similar problem — very high volatility and potentially sleepless nights before taking the final gain.

Consider the chart of monthly volatility for the emerging markets and the US market.

For emerging markets, 36 of the 240 months (about 1 in 6) experienced a 10% or greater swing in value. Of those, 16 (1 in 15; nearly every year on average) were to the downside. If your investment went down 10% in a single month every year of so, could you hold on?

For the US market, 3 of the 240 months (about 1+ in 100) experienced a 10% or greater swing in value. Of those, 2 (about 1 in 100; once each 8 years on average) were to the downside.

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We like the emerging markets, but in moderation and as a well-considered part of a larger asset allocation plan fit to your specific investor profile.