Add Emerging Market Equities To Your Portfolio Now To Boost Its Diversification

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Includes: CIB, EEM
by: Claudio Brocado

Summary

Emerging markets (EM), long considered a risky asset class, will add diversification to your portfolio.

Adding a risky asset to a diversified portfolio actually lowers the overall riskiness of the resulting better-diversified portfolio.

EM is an asset class where active management may actually add more value than in more developed asset classes.

The only free lunch in finance is diversification. A well-balanced portfolio across asset classes (and within equities, which should be the dominant portion of most long-term portfolios) weathers storms such as the current one better than most non-diversified baskets of investments. Something is always going up (in some cases way up) even as most assets seem to be going down, and vice versa. The broader the investment universe, the more likely will be that some segments of it are experiencing sharp bull markets even as other parts of the portfolio are suffering steep declines.

EM equities tend to be more cyclical (and thus, volatile) than stocks of more developed markets. These cycles periodically result in even EM experts questioning whether the equities of developing economies are a viable separate asset class. Being an EM expert has not generally been pleasant in the last few years. Seeing one's asset class underperform so significantly what has generally been a developed country bull market can be frustrating. However, isn't this what diversification is all about? One asset class is likely to be "zagging" even as others "zig" in the short-term volatility (zigzags) that characterize market cycles. This kind of negative correlation is actually a good thing, and one that encourages adding such a volatile ingredient to a global portfolio, in order to increase its overall diversification.

This, again, does not mean to advocate market timing. I steadfastly believe that emerging markets should always be part of a well-diversified global portfolio with a long-term orientation (the only orientation I advocate for equity investors). However, for investors who do not have any EM exposure, this is as good a time as any to be adding such exposure. In fact, as I have recently argued despite my caution against market timing, this is a better time than most to make sure your long-term equity portfolio has EM exposure.

Again, with an investment horizon of five years or more, there is no reason why your global equity portfolio should not have an allocation of some 10% to EM. That seems like a good round number to aim for (10% actually represents a slightly underweight position based on the market cap weight of EM in a global context). EM represents a much larger part of the world when one looks at other metrics, such as the global economy, let alone the world population. Thus, aggressive investors looking for high long-term growth should consider much larger allocations to EM.

Active management actually has a better shot at adding value in EM (vs. global) equities

Active management (as opposed to passive index investing) has a better chance of adding value in EM than in global developed equities. EM equities tend to receive lower coverage by global analysts, so markets in the emerging world are less efficient. Their relative lack of efficiency makes EM more fertile ground for value added on the part of active managers (stock pickers as well as asset allocators). Particularly when one compares the task of an EM portfolio manager to that of a US large cap fund manager, there are quite a few more decisions to make; obviously, many more countries to look at; more economic cycles to analyze; more companies in a very multicultural environment.

In fact, I have long 'objected' to looking at EM through too monolithic lens. Each region, let alone country, is very different from the others. There are too many countries, currencies and companies for anyone to be a real expert. Index investing in EM, however, is not the solution. Whereas I advocate using a low-cost index fund or ETF to invest globally, in EM investors may be better rewarded in the long run by choosing active funds with well-resourced investing teams taking on the task. They may be more likely to look beyond plain-vanilla EM to invest in 'frontier' markets. Did your EM index fund have any exposure to 'frontier' Argentina, for example? It has been one of the best performing bourses of the last couple of years. As always when it comes to mutual funds, however, I advocate owning them only in tax free or tax deferred vehicles -- such as ROTH IRAs or ROTH 401(k) accounts for the former, or traditional IRAs or 401(k) accounts for the latter.

All the above notwithstanding, I tend to focus my notes here more on individual stock picking ideas. I have already mentioned AMX and ITUB for direct EM exposure, as well as SAN and QCOM as rather indirect plays (versus funds). My latest recommendation would be the ADRs of Bancolombia (NYSE:CIB). Bancolombia stock has plunged in recent months to multiyear lows. One of the main reasons, besides the more general EM underperformance, has to do with concerns about Colombia and its currency, driven by the perception on the part of crossover investors that Colombia is more geared to oil prices than it really is. One of the reasons for this misconception may have to do with the fact that foreign investors are generally more familiar with the country's oil-related stocks. Several of them started out trading in Canada, giving foreign investors their initial exposure through stocks available originally only in North American markets.

Disclosure: The author is long CIB, AMX, ITUB, SAN, QCOM.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.