Skip Header

Emerging markets can reap dividends but it’s tricky

Tom Stevenson

Tom Stevenson - Fidelity Personal Investing

This article first appeared in the Telegraph

Emerging markets can reap dividends but it’s tricky

Investing in emerging markets is one of those things that makes intuitive sense but which, if we are honest, we don’t really understand too well. It seems obvious that with the economies of China and India both growing at more than 6% a year, around twice the global average, investors should have a decent weighting to these major developing countries in their portfolios. How to actually get that exposure, however, is more difficult than it looks.

A couple of simple comparisons between emerging and developed markets would seem to confirm the conventional wisdom. Today’s emerging and (smaller, less developed) frontier markets account for 55% of the world’s economic output (when measured using equivalent purchasing power rather than actual exchange rates). That compares with 37% for the developed world. They are also where most of the world’s people live - 59% of the world’s population versus 13% in developed countries. The other 28%, by the way, live in countries where no meaningful stock markets exist and so are not relevant from a direct investment perspective.

Once you move beyond these basic statistics, however, the whole emerging markets investment question becomes more complicated. Knowing how, where and how much of your savings to allocate to the investment class is tricky for a couple of reasons.

First, the definition of what constitutes an emerging or frontier market is not as simple as you might think. Different index providers disagree on the criteria to determine in which group a country should sit. To take one significant example, MSCI describes Korea as emerging while FTSE Russell and S&P think it is developed. As Korea represents nearly 14% of the MSCI emerging market index, the distinction (on the grounds that its foreign exchange market is not fully liberalised) matters.

Second, the weighting of emerging markets in global stock market indices is surprisingly low. In contrast to those GDP and population weightings, the contribution of emerging and frontier markets to global indices is only around 12%. What is even more surprising is that, while this has grown from 2% in 1980, it has not risen at all over the past 10 years.

You might think that this is simply a reflection of promotions into the developed world club as emerging economies have evolved over the years. In fact, there have been surprisingly few changes in status. Portugal was given a place at the top table in 1997 and Greece in 2001 (although it was subsequently kicked out again in 2013). Israel was promoted in 2010. Few in number, these losses were also offset by the additions of Qatar and the UAE in 2014.

The main reason for the relative underweighting of emerging markets is the wholly reasonable caution of the index providers about including stock markets that are hard to access, illiquid or dominated by majority-government-owned companies. One further factor has been the relative underperformance of emerging markets since 2007, a period in which the US stock market has been the stand-out performer.

The recent underperformance of emerging markets raises questions about the conventional wisdom of investing in what seem like the world’s most dynamic and fast-growing regions. So how have they performed in the longer-term? As with other aspects of measuring emerging markets, that is not such an easy question to answer because extended data of sufficient reliability are not that simple to come by.

Thank goodness, then, for our old friends Dimson, Marsh and Staunton at the London Business School and their annual publication, the Credit Suisse Global Investment Returns Yearbook. In this year’s recently-issued edition, they have undertaken the Sisyphean task of putting together a 119-year emerging markets index, starting in 1900. When you consider the fact that some countries like Argentina and Chile were deemed developed in 1900 but fell from grace, that key markets like China and Russia were closed completely for decades, and that benchmarks like MSCI’s emerging markets index didn’t appear until the 1980s, this is a stunning achievement. I’m glad to be reading their work rather than doing it.

The short answer to the performance question is, you may not be surprised to hear, ‘it depends’. First, it depends which time period you choose. Over the whole 119-year period, emerging market shares have underperformed their counterparts in developed countries. But that largely reflects the late 1940s when Japan lost 98% of its value and China was wiped out completely. From 1950, emerging markets have staged a long relative recovery, delivering an annualized return of 11.7% against 10.5% for developed markets.

At the individual country level, nine of the top ten emerging markets have done better than the average for the developed world. Interestingly, the laggard has been China which has underperformed despite being the largest emerging market and having enjoyed long and high economic growth. Perhaps unsurprising is the fact that higher average performance has come with higher average volatility. Only South Africa among the top ten has provided a smoother ride than the average developed market.

Given the challenge of measuring emerging market investments, or indeed defining them, how should an investor go about including them in a portfolio? First, I would suggest, avoiding trying to second-guess the future performance of an individual market. The chance of getting this right is low. Rather be well-diversified by investing in a global emerging markets fund. This points to my second recommendation - don’t overestimate your ability to spot individual shares in emerging markets. This requires due diligence, local knowledge and boots on the ground. It’s worth paying a bit extra for that. Finally, don’t discount investing in emerging markets through developed markets. BMW knows a lot more about the Chinese car market than I do.

More on emerging markets: Picking tomorrow’s winning markets

 

Important information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.