The Rising Risk of Emerging Markets

Includes: EEM, EFA, IWV
by: James Picerno

There's a whole lot of stress-testing going on these days in the capital markets. And one of the striking lessons is that emerging markets have proven to be far more durable than many investors, including yours truly, thought possible. Yes, the durability could evaporate tomorrow for all we know. But for the moment, it's hard not to be impressed by the resiliency of equities in the developing world.

Consider the table below, which compares the major asset classes and ranks performance by May 2008 total returns (click to enlarge). Once again, emerging markets were the clear winner, rising by more than 3% last month. Other than commodities, emerging markets equities are comfortably in the lead for the past year through May 31, 2008 as well.

Yes, there have been some tough spots along the way, as there inevitably are for all the major asset classes. This year's January and March were especially hard on equities in emerging markets, which suffered dramatic declines in those months. Nonetheless, it's hard to overlook the fact that despite all the turmoil in the global economy--from wars to price shocks in energy and food to various political and weather-related disturbance--this slice of the world's stocks has held up remarkably well.

Let's take a look at the longer term for some historical perspective. The iShares MSCI Emerging Markets (NYSEARCA:EEM) posts a 33% annualized total return for the five years through May 31, 2008. By comparison U.S. stocks are up by an annualized 10.3% over that span, as per iShares Russell 3000 Index (NYSEARCA:IWV). Foreign equities in the developed world, mainly Europe and Japan, look a bit better than the U.S., with a 18.9% annualized total return via the iShares MSCI EAFE Index (NYSEARCA:EFA), although that still pales next the emerging markets.

On one level, there's nothing particularly surprising about emerging markets' superior performance. Indeed, these markets are higher-risk economies and so the higher return is compensation for bearing that risk. One measure of risk, although hardly the only one, is price volatility, and by that metric MSCI Emerging Markets Index is nearly twice as volatile (based on trailing 3-year annualized standard deviations) as either MSCI EAFE or Russell 3000 indices, which represent foreign-developed equities and U.S. equities, respectively.

The bottom line: Emerging markets have soared through thick and thin in recent years. There have been mini corrections, but so far this asset class has yet to suffer a major setback. That alone makes me nervous. Parties, after all, don't go on forever, and higher risk eventually lives up to its reputation on the downside.

Yes, there are strong arguments for why emerging markets should prosper in the years ahead. We don't dismiss those arguments and, in fact, we're a believer in the idea that the developing world will continue to shine as a long-term proposition.

But everything has limits, including the idea that emerging markets are immune to the various economic, financial and political viruses that stalk the globe. Note that the trailing dividend yield for emerging markets (as per the S&P/Citigroup Emerging Markets index) at the end of April 2008 was a relatively spare 1.9%, down from more than 3% as recently as July 2005. No doubt the yield is even lower as of Friday's close, after emerging markets' robust rise in May.

What's a strategic-minded investor to do? Cut back on emerging markets. Not completely, although if you've been riding this wave for several years, your portfolio's allocation to emerging markets is surely overweight by more than a little, relative to Mr. Market's allocation. As of last Friday, the float-adjusted capitalization of the world's emerging markets represented just under 11% of global equity market capitalization, according to numbers from S&P/Citigroup indices--more than double from the start of 2004.

Yes, strong growth in emerging markets in recent years warrants a rising share of the global market capitalization for this realm. As such, there are many reasons why strategic-minded investors might want to put more than 11% of their portfolio into emerging markets stocks. In fact, asset allocation is inevitably a customized decision that's specific for each investor's particular situation. Nonetheless, by my reckoning (and imperfect expectations of the future), we're of a mind to venture no higher than a market weight, if not a below-market weight allocation in emerging markets. The reasoning starts with respecting the financial laws of gravity.