September 2010

By: Brett Hammond, Chief Investment Strategist
Brett Hammond is a managing director and Chief Investment Strategist for TIAA-CREF Asset Management. His group is responsible for asset allocation modeling and institutional advising, economic and market commentary, and investment product and portfolio research. 

• Emerging market countries generally experience faster economic growth than developed countries, creating attractive equity investment opportunities.
• While emerging market equities offer significant return potential and diversification benefits, they are also more volatile than developed market equities.
• Historically, emerging market equity returns have low correlations with returns of many other asset classes. During times of extreme volatility, however, equity markets tend to move more in tandem, reducing diversification benefits.
• Given their characteristics, emerging market equities should be considered a long-term investment, rather than a short-term market play.

Emerging market equities represent a small but dynamic asset class that is gaining in importance. Over long periods of time, emerging market equities as a whole have produced higher returns than developed market equities. But the risks of investing in emerging markets are as dynamic as the potential rewards. 

Higher volatility is a hallmark of this asset class. For example, during the global economic downturn in 2008, the major emerging markets stock index plunged 53%, then rebounded 78% in 2009. This compares with a drop of 37% for the S&P 500® Index in 2008, followed by a 26% rebound in 2009.

So how should we understand emerging market equity investing? We can start by asking four questions:

1. What is an emerging market?
2. What is the basic source of emerging market equity returns?
3. How do emerging markets behave over the short and long run?
4. Why has the emerging markets asset class recently become more attractive for investors, and what role should it play in a diversified portfolio?

1. What is an emerging market?

Of the world’s 195 independent countries, only a small subset is included in a major global stock market index. The major non-U.S. developed country stock market index (MSCI EAFE)¹ contains 22 countries; another 21 countries are included in the major emerging markets index (MSCI EM)². In general, emerging market countries have high potential economic growth rates, attractive market valuations, and equity returns that normally do not move in lockstep with those of other asset classes. Today, emerging markets as a whole represent more than 80% of the global population and 50% of its economic output.

But it is not the size of a country’s overall economy that determines its inclusion in the MSCI Emerging Markets Index. Instead, criteria focus on the size, depth, breadth, and transparency of the country’s equity capital market, as well as the availability of stocks for purchase by foreigners.

China, India, and Russia, for example, are among the most prominent emerging stock markets—in large part because, over the past decade, they have liberalized previously draconian capital controls that had restricted foreign purchases and sales.

2. What is the basic source of emerging market equity returns?

The risks and rewards of emerging market equity investing in any country are closely tied to overall economic development. The availability and use of capital and labor, education levels, and intangible elements such as an evolving political system can drive equity market dynamics and performance.

Attractiveness also depends on whether a country’s stock market is well developed. Do businesses commonly turn to the equity markets for capital? Is it easy to buy and sell company shares? Is there sufficient information and regulation to ensure that investors can be confident of fair treatment?

Consider China and India. Hardly a day goes by without a story about China, which, by some measures, has become the world’s second-largest economy. China’s economy and stock market are developing rapidly and will likely continue to do so for some time.

India, however, which gets much less attention in the media, is a more balanced economy. India depends far less than China on export markets, has a highly educated workforce, a growing middle class, and two other important factors: Its rule of law and legal system are more developed and transparent than China’s, and its demographics are more favorable. China’s population is aging rapidly—so much so that the country is likely to become old before it gets rich. India’s more youthful and evenly distributed population by age means it should have a larger ratio of workers to retirees for decades to come.

These contrasts demonstrate that each emerging market country has its own experience and potential. They tend to exhibit far more economic variation than their developed country counterparts. One thing that many of today’s emerging market economies have in common: They will be developed economies by 2050.

3. How do emerging markets behave over the short and long run?

Reflecting differential economic growth rates during the past 20 years, average annual returns of emerging markets were more than double those of developed country markets. These higher returns came with considerably more volatility. During the same 20-year period, returns of the MSCI Emerging Markets index were 60% more volatile than those of the MSCI EAFE (developed country) index.³

On a year-by-year basis, emerging market equity returns as a whole ranged from –54% to +75%, while returns in developed markets varied from –42% to +31%. Among some individual country markets, returns varied even more. Of course, the historical experience is not a predictor of future returns and volatility.

Because of their performance behavior, emerging market equities provide potential portfolio diversification benefits for investors. For example, between 1988 and 2010, the U.S. stock market had a correlation of about 75% with other developed country markets, but only about 55% with emerging markets. Developed markets as a whole were correlated about 75% with emerging markets. (A correlation of 100% would mean the markets moved in lockstep.)

Within emerging markets, correlations vary considerably, but generally are low. Among Brazil, Russia, India, and China, correlations during the same 1988-2010 period ranged from about 35% (India and Russia) to about 55% (Brazil and Russia).

4. Why has the emerging markets asset class recently become more attractive for investors, and what role should it play in a diversified portfolio?

It’s important to understand that correlations among stock markets can vary considerably over time. During the global economic recession of 2008 and 2009, correlations among stock markets of all countries rose dramatically. In other words, stocks of many countries fell painfully into lockstep as economies and markets declined. This reduced diversification benefits for investors during that period.

Anticipating broad economic recovery, stock markets in many countries remained more highly correlated in 2009. Today, we can see clear differences in the pace of recovery around the world. China, for example, has made remarkable strides and is back to near double-digit growth rates. India’s economy, along with the economies of some other emerging market nations, is not far behind.

The developed world, for the most part, is recovering much more slowly. Germany is leading the way with an expected growth rate of about 3% in 2010; the United States is far behind, at about 2%.

Recent stock market performance reflects these varying rates of economic growth. During the first six months of 2010, emerging market equities outperformed their developed country counterparts. As a result, correlations are beginning to decline again, reinforcing the appeal of emerging market equities as an attractive source of portfolio diversification over the long term.

Conclusion

Because of their unique characteristics, emerging market equities offer significant reward potential accompanied by significant risk. Therefore, an allocation to this asset class should be considered a long-term investment rather than a short-term market play. While the exact amount or proportion of emerging market equities in a diversified portfolio will depend on the investor’s individual situation and risk orientation, a modest increment may provide the potential for greater risk-adjusted returns.

Investors interested in emerging market equities should consult a trusted advisor to determine an appropriate role for this asset class in their overall portfolio.