One of the worst performing market sectors in 2008 has been emerging market equities. The iShares MSCI Emerging Markets Index (EEM) exchange traded fund has lost 28.6% year-to-date. Most of this decline has occurred in the past three months, with EEM falling by 22.8%.
The major slump in emerging markets can be attributed to a number of factors, including:
- Fears that slowing growth in the U.S. and Europe will be a drag on growth in emerging markets.
- Profit taking. When the correction began, emerging markets stood as one of the last places where profits could still be reaped. Even with the steep decline in value, 5-year annualized returns for EEM are 19.8%, compared to 6.2% for the S&P 500 Index.
- Rising oil prices. China and India are major importers of foreign oil. Higher energy prices could significantly dampen growth and stimulate inflation for these economies.
- A recovery in the dollar. Of the 22.8% decline in the EEM over the past three months, almost 5% was related to a stronger dollar.
- Political tension between Russia and Georgia.
While steep corrections are relatively frequent occurrences in the emerging markets, they often present great long-term buying opportunities. And the case for investing in emerging markets should be made with a long-term perspective.
Although short-term volatility is likely to persist for the emerging markets, the long-term trends are clearly in place. The adoption of capitalism, the acceptance of market and political reforms, the growth of middle classes, and the implementation of new technologies are driving rapid growth in the economies of China, India, Russia, Brazil and many others developing markets.
Just 20 years ago, the prediction that Americans would be able to buy Chinese and Russian stocks on the New York Stock Exchange, or that China would be the largest owner of U.S. Treasury securities, or that Moscow would be the home to more billionaires than any other city (33 according to Forbes) would have been met with great skepticism.
Indeed, the world has changed tremendously, and as a result, emerging markets should continue to grow at a faster pace than developed markets. While this seems to be stating the obvious, it is the most compelling reason why U.S. investors should have emerging market exposure.
For many years, emerging markets sold at valuation discounts to developed markets. This reflected the view that emerging markets possessed higher risks due to more volatile economies, less developed regulatory systems, and less stringent accounting standards. However, it now is much harder to make the case that developed markets such as the U.S. have lower risk, considering the recent technology and housing bubbles, the high profile accounting scandals at Enron and WorldCom (along with many others), the option backdating scandal and now the meltdown of the U.S. financial sector (subprime mess).
After the recent steep correction, emerging markets are again selling at a discount to developed markets. EEM is now trading at 11.9 times next 12 months estimated EPS versus a forward P/E multiple of 13.2 for the S&P 500 Index.
The combination of higher long-term growth prospects, a more comparable risk profile relative to developed markets, and a reasonable valuation makes emerging market equities very attractive at this point in time. EEM, which tracks the MSCI Emerging Markets Index, provides a solid way to play this sector. And although it has less history, the Vanguard Emerging Markets Stock ETF (VWO) also looks attractive, especially considering that at 0.25%, its expense ratio is 0.49% below that of EEM. That should translate into a performance advantage over the long-term.
Of the actively managed funds, Morgan Stanley Emerging Markets (MSF) has delivered solid long-term performance and has a track record that spans almost 20 years. Its expense ratio of 1.46% is reasonable for an actively managed emerging markets fund. An added bonus is that this closed end fund can usually be purchased as a discount to its net asset value. The current discount is 8%.
Disclosure: Author owns a position in VWO and MSF and manages accounts which hold VWO and MSF.