Putting Emerging Markets In Their Place

The annual study of long run global investment returns by three London Business School academics (Dimson Marsh and Staunton) has the great advantage of puncturing popularly held but fallacious arguments much favoured by those hawking their financial service wares – be they brokers, fund managers, investment bankers or financial advisers.

The headline findings from the latest edition address the arguments for investing in emerging markets and/or countries where economic growth is highest (although there are other interesting findings that will be the subject of a separate comment in due course). The academics emphasise that in both cases the emerging markets/growth story is not quite as good as its advocates make out.

Here are some of their findings:One, emerging markets have had a terrific decade, delivering on average 10% per annum between 2000 and 2009., while equities generally – as represented by the MSCI world index –  have produced a zero % return. Individual emerging markets have done even better.

Two, this exceptional relative return  has been offset in part by the higher volatility of emerging markets, which is roughly 50% greater than that of developed markets.

Three, the longer run superiority of emerging markets is less clear-cut. If you look at the data since 1978, for example, when the first emerging market indices were started, developed country stock markets have actually outperformed emerging markets by a small margin, though that is down to the early years, not more recent ones.

Four, such evidence as there is about the really long term historical record suggests that emerging markets can take a long time to make the transition to developed status. Of 34 countries that had stock markets in 1900, only five have made the step up from emerging to developed status in the 110 years since then, while two (Argentina and Chile) have gone the other way. (Three other countries that either did not exist or had no stock market in 1900 – Israel, Singapore and  Taiwan – have also joined the developed market club, defined as countries with GDP per capita of $25,000 per annum, in the meantime).

Fifth, what does remain the case for emerging markets is their value as diversifiers for western investors. Owning a basket of emerging market index funds reduces risk without reducing returns, the classic free lunch. Even here however, the value is diminishing as globalisation has sharply increased the correlation between emerging markets and developed markets, as the financial crisis in 2007-09 underlined.

Sixth, there are a number of reasons why investors may be disappointed when trying to capture higher returns from emerging markets. Only a small proportion of an emerging country’s growing companies will be listed on a stock market. Those that are may not be growing as fast as the average; many are utilities or State-owned enterprises, often with small free floats.

In addition, there is the classic problem that investors may already have priced in the expected higher growth, reducing the potential returns on offer and risking disappointment for those who join the party too late. One of the clearest messages from history, one that academics have highlighted for many years,  is that investors always tend to overpay for a good growth story.

Finally, the professors produce some interesting research which shows that GDP growth is a poor predictor of future financial returns. This paradox is explained by the fact that GDP figures are only known for certain some time after the event: if you are smart enough to know for certain which countries will have the highest growth in future, you can make excess returns – but in practice that certainty is rarely available. In practice we don’t usually know what GDP was last year (let alone next year) until some time after the event.

It is important to emphasise that none of this is a reason for avoiding emerging markets, which will continue to grow in size and importance over the coming years – as everyone knows, China is on course to overtake the USA as the largest economy in the world by 2020. But investors make returns by buying at a good price, not just by being in the right place at the right time.

The case for emerging markets, in other words, is often oversold – or at least sold on poorly founded evidence. The LBS academics reckon that long run outperformance by emerging markets could be worth 1% per annum of additional return, but not much more. It is a reward for the higher risk, not for higher growth. How much you pay for that growth makes all the difference.