Sometimes an investment idea is so strong, it bears
#-ad_banner-#In late February, my colleague Michael Vodicka
implored readers to
give emerging market stocks a fresh look
. Though he cautioned that these struggling markets may not have
yet hit bottom, he added that "the MSCI Emerging Markets Index is
trading at just 11 times earnings. Not only is that a massive 40%
discount to the MSCI World Index, it's the widest gap since the
financial crisis of 2008 and a 10-year low." As a potential
catalyst, Michael noted that the recent price rebound for many
commodities should help bolster a number of emerging market
But there's another, even more powerful reason to own emerging
markets, which merely strengthens the investment case: They
reduce risk. That may seem counterintuitive, so let me
Back in November, S&P Capital's Global Equity Strategist Alec
Young took a look at historical market returns to identify how
domestic and foreign stocks performed each year. If these two
asset classes merely mirrored each other, then there would be no
need to own foreign stocks. But as we saw in 2013, U.S. stocks
soared, while emerging markets slumped.
The advantage to owning asset classes that have divergent
returns is that a broad-based portfolio can smooth out
volatility. Said another way, such a mixed portfolio can reduce
risk by delivering non-correlated returns, delivering higher
risk-adjusted returns. Young's conclusion: "the 'sweet spot' on
the efficient frontier, or the allocation that produced the
highest risk adjusted returns was a 70% domestic allocation
coupled with a 30% foreign weighting."
Not only did such a portfolio beat a basket of U.S. only
stocks over the past 40 years, but "the 70% to 30% U.S.-foreign
allocation also produced a higher risk adjusted return than the
19 other possible domestic-foreign allocations we analyzed," he
Of course, foreign stocks comprise everything from
multi-billion dollar Swiss drug giants to small-cap retailers in
Indonesia. Simply focusing on blue-chip stocks in well-developed
economies in Europe are not going to provide much diversification
with U.S. stocks. For example, the
Vanguard FTSE European ETF (NYSE:
has traded in lockstep with the S&P 500 over the past year,
with both the Europe ETF and the U.S. index delivering a roughly
Of course any investment in emerging markets over the past
year may have seemed mistaken. Indeed, warning signs emerged back
in late 2012, led by the plunge in commodity prices that would
have clued investors in to a timely exit. But S&P's Young
isn't talking about near-term results, simply because we really
don't know how foreign stocks will perform in any given year.
Make no mistake. You don't need to absorb massive risk by
owning emerging-market stocks and funds -- if you choose the
right assets to own. Young recommends shares of the
iShares Core MSCI Emerging Market ETF (NYSE:
, which owns stable companies such as
China Mobile (NYSE:
Right now, that's about as far as many U.S. investors want to
go with their foreign exposure.
As recently noted in The Wall Street Journal
, "after years of distortion from crisis and crisis response, the
world is rebalancing. For emerging markets, the path will surely
Yet that article also notes that emerging market economies
tend to carry a lot less debt than the U.S. and European
economies. And many of the most troubled emerging markets are
still far healthier than they were when prior economic crises
spread across the globe.
To be sure, emerging markets don't outperform developed
markets over the long run,
as this recent article in The Wall Street Journal
. "But emerging markets have tended to do stunningly well over
shorter periods when investors neglected or rejected them," the
As an example, emerging markets slumped badly when the dot-com
bubble imploded here in the U.S.
"By 2001, assets at emerging-market funds had dwindled 20%
from 1996, and many investors gave up; in 2001 alone, they pulled
out 6% of their money ... Naturally, between 2001 and 2010,
emerging markets returned an average of 15.9% annually, while
U.S. stocks grew at an annualized average of 1.4%." The key
takeaway: The best time to focus on emerging markets is when
others have shifted assets elsewhere.
A Top-Performing Mutual Fund
In addition to the exchange-traded funds (
) cited by S&P's Young, investors should also consider the
Harbor International Investor Fund (Nasdaq:
. "This fund has generated exceptional performance by ignoring
short-term volatility and focusing on the long term," according
to Morningstar, which gives it a "gold" rating.
The approach used by this mutual fund's portfolio managers
speaks for itself: "Management looks for long-term catalysts that
may not materialize for three to five years or more, opening it
up to a broad range of opportunities. Rather than spending time
trying to guess a company's near-term earnings, the team looks
for structural shifts that will affect industry pricing power and
competitive advantages, which drive profits over the longer run,"
writes Morningstar's Kevin McDevitt. The approach has yielded a
21% annualized gain over the past five years, and equally
important, the key holdings in the portfolio aren't
tightly-correlated with U.S. stocks.
Risks to Consider:
If you have a six or 12-month time horizon, then you should
never invest in emerging markets. They can radically underperform
the developed markets in any given year, as was the case in 2013,
and could still be the case in coming quarters.
Action to Take -->
If you have a longer-term time horizon, then history suggests
that you're bound to generate strong returns form emerging
markets, simply because we have been through a period of
underperformance. It's an asset class that zooms into and out of
favor, and right now, the current disdain for them, along with
their non-correlation with U.S. stocks, gives them the potential
for a solid rebound.
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