Is 5% of Emerging Markets Too Little?

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Includes: EEM, EFA
by: IndexUniverse

By Murray Coleman

How much can a sliver of a high-octane ETF really add to the long-term prospects of your portfolio?

Let’s take the example of a simple, two-fund portfolio designed to provide broad exposure to international stocks. For the sake of argument, we’ll take the iShares MSCI Emerging Markets ETF (NYSE: EEM) and the iShares MSCI EAFE ETF (NYSE: EFA).

Developing markets can include gut-wrenching price swings. But those willing to include a bit of a fund like EEM into a diversified portfolio should reasonably expect greater long-term rewards. Of course, that's assuming increased risk will eventually bring about outsized returns.

Conventional reasoning would make EFA the more conservative bet. It includes the bigger and more developed parts of the non-U.S. investment universe – namely Europe and Japan.

The question with emerging markets – as well as other more volatile sector and commodity funds – is how much do you really need to throw into the mix in order to obtain the best returns with the lowest amount of risk?

A lot of people prefer around 5% in emerging markets. Some prefer less in order to sleep better at night. Bolder types will go with even more.

Over five years heading into Monday, according to Morningstar data, an international stock portfolio using the following allocations to EEM (with the rest adjusted to go to EFA) would’ve generated the following average annualized returns::

  • 5% (EEM): 5.99%
  • 4%: (EEM): 5.85
  • 3% (EEM): 5.72%
  • 2% (EEM): 5.59%

As you can see, splitting your allocations into either a 5% slice or a 2% sliver would’ve meant a difference of some 0.40% in returns. Interestingly, using one of my favorite (free) portfolio management tools, the portfolio with 2% EEM and 98% EFA had a risk score of 131. (An average market rating is considered to be right at 100). Going up to 5% EEM and 95% EFA only raises that Risk Grade to 132.

So what happens if you go the other way? Let’s look again at the returns over the past five years of increasing the slice of EEM in such a two-fund portfolio (and, again, adjusting EFA’s levels to equal a total of 100%):

  • 6% (EEM): 6.12% (Risk Grade of 132)
  • 7% (EEM): 6.25% (Risk Grade of 132)
  • 8% (EEM): 6.38% (Risk Grade of 132)
  • 9% (EEM): 6.50% (Risk Grade of 133)
  • 10% (EEM): 6.64% (Risk Grade of 133)

The lesson here (admittedly using a fairly short-term window) is that you really could make an argument for improved risk-return profiles by increasing portfolio weightings in a broadly diversified emerging markets fund from a very small bit player to take a low double digit bite.

The point is that diversifying into too small of a slice in any asset class might actually be playing against your portfolio’s best interests. There’s something to be said for giving an asset class enough of a presence to make a difference.

I know many of my investing friends who’ve been doing this for awhile caution me that a 2-3% slice might not even be worth bothering – especially with smaller portfolios.

One of the smartest and most experienced investors I’ve ever met, author and financial writer Taylor Larimore (who has been a guest columnist at IndexUniverse.com in the past), doubts whether less than a 5% allocation to almost any asset class will prove over the long-run to be a difference maker.

That might prove to be a difficult assessment to ignore.

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