Are Emerging Markets Worth the Hassle? History Says Yes

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After underperforming the S&P 500 for the past several years, emerging markets represent relative bargains, especially in terms of P/E ratios and dividend yields. Then again, it's easy to conclude that investing in still-developing economies provides limited rewards for too much risk.

#-ad_banner-#Frankly, this is a debate that pops up almost every decade. Back in 1997, Asian markets crashed on the backs of a currency crisis, and investors soon realized that they could do just fine staying close to home: While emerging markets sought to regain their footing in 1998 and 1999, U.S. stocks soared.

But over the next decade, the iShares MSCI Emerging Markets Index ETF (NYSE: EEM ) rose 10.9% annually, compared with a 1.3% annualized gain for developed markets.

Perhaps a longer view is warranted. If you are building a retirement portfolio, you're more likely to be concerned about what kinds of markets can deliver upside over the course of a generation.

Well, a pair of strategists at Credit Suisse have gone a step further... and sought to answer that question with a century-long view. These strategists looked at the returns delivered by various markets going back to 1900 -- and came up with some pretty surprising conclusions.

First, these strategists seek to dispel the long-standing myth that emerging-market economies are built on very weak foundations, ready to crumble at the first tremor. "Emerging markets are in far better shape today than in the 1980s and 1990s," they write.

Back then, these economies were characterized by scant currency reserves, incompetent central bank policies, high levels of inflation and endemic corruption. These days, foreign currency reserves are much higher, and central bankers deploy the same policies used in the U.S. and Europe.

That may explain why even with the underperformance of the past five years, emerging markets shouldn't be shunned. "Despite recent setbacks, from 2000 to 2013, the terminal wealth accruing from investing in emerging markets was almost twice that from an equivalent investment in developed markets," the authors write.

You could argue that even this time period is still too small a window to know whether these emerging markets are worth the higher volatility they experience. The Credit Suisse strategists found that the longer view is more favorable to developed markets. They reconstructed a hypothetical basket of developed markets versus emerging markets, and going back to 1990, the developed markets returned 8.3% annually against 7.4% annualized returns for emerging markets.

Notably, all of the outperformance has come since the end of World War II. Before then, both of these asset classes had moved in lockstep.

But looks are deceiving: Developed markets did so much better than emerging markets in the five years after the end of World War II, that the emerging markets spent the rest of the century trying to make up for that underperformance. "From 1950to 2013, (emerging markets) achieved an annualized return of 12.5% versus 10.8% from developed markets. This was insufficient, however, to make up for their precipitous decline in the 1940s," the strategists note.

Another key trend that has developed: Emerging markets are no longer quite as scary as you'd think. Sure, they've lagged behind developed markets in the past few years, but they are also much less prone to neck-snapping plunges these days.

Back in 1980, emerging markets were twice as volatile as developed markets. Yet by the end of 2013, "the ratio had fallen from 1.9 to 1.1, (meaning) the average emerging market was by then only 10% more volatile than the average developed market," the strategists conclude.

This look in the rearview mirror is helpful, highlighting that developed markets have delivered outsized gains since 1900, though emerging markets are less volatile (that is, risky) than many would have guessed. Indeed, emerging markets have been ripening as an asset class for several decades.

Back in 1980, emerging markets represented just 1% of the global stock market's value. Today, that figure stands at 18%, thanks to the impressive growth in valuations in China, Brazil and elsewhere. Still, that figure discounts the fact that emerging markets now represent 33% of all global economic activity.

The key conclusion from these Credit Suisse strategists: "These weightings are likely to rise steadily as the developing world continues to grow faster than the developed world, as domestic markets open up further to global investors, and as free float weightings increase. Emerging markets are already too important to ignore," they conclude.

Risks to Consider: Emerging markets are capable of steep drops in any given quarter or year, so you should only own them if you have a multi-year time horizon.

Action to Take --> How you invest in emerging markets is another key consideration. The iShares MSCI Emerging Markets exchange-traded fund is quite popular, with $35 billion in assets. But such ETFs typically own blue-chip companies that conduct a large portion of their business in developed markets, even if they are domiciled in emerging markets. I prefer to focus on stocks and ETFs that directly focus on the key theme of emerging markets: fast-growing middle classes. The EGShares Emerging Markets Consumer ETF (Nasdaq: ECON ) is a solid choice. And WidsomTree offers a variety of funds (often country- or region-specific) that target emerging-market consumers.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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