Are Emerging Markets Worth The Risk?

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Includes: EEM, VWO
by: Logan Kane

Summary

Investing in emerging market stocks has long been fashionable, particularly for institutional investors.

However, when digging through the historical data, I find that emerging markets have a much higher level of risk for a slightly higher expected return.

A fallacy that investors have is that higher GDP growth equals higher equity returns. It doesn't. However, there is a much stronger negative correlation between political instability and equity returns.

Either avoid investing in emerging market stocks or tilt your portfolio towards quality and political stability.

Emerging market stocks have underperformed over the last ten years.

The thesis for investing in emerging markets is simple but wrong. Higher GDP growth in emerging markets should theoretically lead to higher equity returns over time. Yet, history shows that there is actually little to no correlation between GDP growth and equity returns. However, there is a much stronger negative correlation with equity returns and political instability. Moreover, emerging markets are prone to dramatic price swings and tend to melt down when investors need liquidity the most. While there are valid reasons for investing in emerging markets, blindly assuming stock returns follow GDP growth is wrong. I recommend focusing on investing in quality economies or simply not bothering.

There isn't a strong correlation between GDP growth and stock market returns.

Source: International Monetary Fund

IMF data over the last shows that there is a surprisingly weak link between GDP growth and equity returns. If GDP growth rates had a strong correlation with stock returns in OECD countries, then you would expect the data to form a line from the bottom left to the top right. That's not at all what the data shows. A larger study from Vanguard paints a similar picture. Many countries with strong GDP growth see real equity returns underperform their real GDP growth.

Source: Vanguard

Academic research shows a strong negative correlation between political instability and stock returns. Since research only shows a weak correlation between GDP growth and stock returns, it seems that we should challenge our assumptions about GDP growth, political instability and returns. Most stock markets are majority owned by their own citizens, so it's not a strong assumption that you aren't getting properly compensated for political risk when you invest in one or more emerging markets.

Emerging markets have consistently more risk

Depending on your time period, emerging market stocks have roughly 7-8 percentage points more volatility per year than the S&P 500 (SPY) has had. And over the last 20 years, the premium for owning emerging markets (NYSEARCA:EEM) or (VWO) has only been around 1 percent per year. I'll grant that you have some large bull and bear markets in there, but the reward doesn't justify the risk.

Over the last 15 years, you started with an epic bull market, followed by a huge liquidity crisis in 2008. Then you got a huge rebound, 3 years of nothing, another bear market, a quick bull and now another drop. The whole time, you were paying 70 basis points plus per year in fees/transaction costs for the privilege of riding the rollercoaster.

Source: Yahoo Finance

Source: Federal Reserve

All in, you roughly tripled your money (less fees). Meanwhile, Chinese GDP has increased sevenfold (China is the largest component of EEM). This is an obvious disconnect. The most plausible theory is that GDP growth doesn't necessarily lead to earnings per share growth, which ultimately drives equity returns.

Furthermore, when you are most likely to need liquidity (like 2008), emerging markets aren't going to be there for you. Financial advisors can't really sell the outperformance of EM since it hasn't existed for 10 years, so they often rationalize to clients that emerging markets have a low correlation to other asset classes. This is true and false. During times of relative peace and prosperity, emerging markets do indeed have a low correlation with domestic equities. However, during times of systemic stress and panic, emerging markets get absolutely destroyed–their correlation with other risk assets approaches 1 and downward betas surge.

During times of economic stress, money flows to safe assets like treasuries. People dumping risky assets to buy treasuries pushes up the value of the dollar, which is a problem because our investments abroad need to earn more in local currency to match the same exchange rate adjusted return. Also compounding the issue is the fact that many companies (and countries) in emerging markets are fond of borrowing money in U.S. dollars, which carry a lower rate of interest than typical emerging market currencies. If the dollar appreciates enough against the local currency, it is increasingly difficult for foreign borrowers to service their loans (they earn in local currency, but they owe dollars to creditors). This can cause bona fide debt crises in emerging markets (see Turkey, Argentina), but also puts pressure on more established markets like China.

Political Risk

Corruption is a big problem in emerging markets.

You can learn more about emerging market politics from living a couple of years in Miami than you'll ever learn in an economics textbook. The upper classes of third world countries absolutely plunder their companies (and governments). Then, after getting rich, they disappear. The staggering level of corruption outside of the Anglosphere and Western Europe means that when you invest in emerging markets, you can expect that despite generally low tax rates, the combined influence of taxes and corruption add up to a high effective tax rate on your investments. Beyond the obvious corruption, you also get a lot of plainly bad policy decisions. Trade wars (and actual wars) fall into this category.

When EM governments get in trouble, they invariably tend to abusively monetize (print money to pay) their debt. Then there's other stuff, like the puzzling decision in India to ban 90 percent of cash last year. It's actually not puzzling when you realize it was designed to redistribute wealth from working people to the rich. They failed at even achieving a windfall of it, as over 99 percent of the cash eventually trickled back in before the deadline.

Many emerging market politicians think nothing of borrowing money they probably can't pay back, enriching themselves and their friends, and hiding in exile in South Beach for the rest of their lives. To be fair, this isn't as true anymore for China, Taiwan, and South Korea, which make up ~57 percent of the index, but it's true for the rest.

Without a quality filter, you aren't much different than a restaurant owner with thieving bartenders and waiters by investing across the board in emerging markets. By filtering out political instability, you stand to also filter out negative returns also. Unfortunately, this complicates the process of investing in emerging markets. You can't just set your investments and forget about them.

Conclusion

Investors seeking to outperform the market often invest money in emerging markets for the perceived risk premium to domestic equities. Maybe they shouldn't be. There are safer and easier ways to collect superior returns, like factor tilting (like small-cap, quality, momentum, and value). While investing in developed (or at least stable) international markets is a good idea, emerging markets tend to crash when the U.S. economy falters, have more risk and barely return more than domestic stocks. If I were you, I'd look to find superior returns elsewhere, at least as long as US dollar interest rates are rising.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.