When Emerging Markets Outperform

Earlier this week, we looked at emerging markets and why many investors stick to domestic stocks due to two biases: home country and recency, despite a compelling case for emerging market investing.

To more fully understand the case for global diversification, I’ll resume the discussion with an exploration of two studies related to emerging markets.

The Importance Of The Book-To-Market Ratio

Michael Keppler and Peter Encinosa, authors of “How Attractive Are Emerging Markets Equities? The Importance of Price/Book-Value Ratios for Future Returns,” which appears in the Spring 2017 issue of the Journal of Investing, provide us with some further insights as to returns we might expect from emerging markets.

For the period January 1989 through October 2016, the authors found that the P/B ratio of the MSCI Emerging Markets Index ranged from a low of 0.90 in January 1989 to a high of 3.02 in October 2007, and averaged 1.75. They then divided the P/B range into three intervals and found:

  • For 10 observations, the P/B ratio was below 1.22. The average annual return in U.S. dollars in the four years that followed was 12.9% and never fell below zero.
  • For 273 observations in the second interval, the P/B fell between 1.22 and 2.76. The average annual return in the four years that followed was 9.4%.
  • In four observations, the P/B ratio exceeded 2.76. The average annual return in the four subsequent years was -5.1%, and was always negative.

Wide Dispersion Of Outcomes

As noted earlier, the current P/B ratio is 1.5, near the bottom of the range for the interval during which the MSCI Emerging Markets Index returned 9.4% over the succeeding four years, and not that far above the interval that produced 12.9% returns over the succeeding four years.

Keppler and Encinosa concluded that there has been a negative relationship between the P/B ratio and future returns in the emerging markets. They also warn investors that focusing on average returns hides a wide dispersion of outcomes.

For example, while their regression analysis led them to forecast a return of 12% per year for emerging markets over the ensuing four years, the data from the prior 28 years indicate the extreme outcomes lie between an annual loss of 8.8% and an annual gain of 36.9%.

Further Findings

Keppler and Encinosa also found the same negative relationship between the P/B ratio and returns in the subsequent four years in the developed markets. Over the period 1970 through October 2016, they found the lowest P/B ratio was l.01 in July 1982, the highest was 4.23 in December 1999 and the average was 2.06. Again, dividing the period into three intervals, they found:

  • For 169 observations, the P/B ratio was below 1.70. The average annual return in U.S. dollars in the four years that followed was 15.4% and was never below zero.
  • For 319 observations, the P/B ratio was between 1.70 and 3.46. The average annual total return four years later was 7.2%.
  • For 27 observations when the P/B ratio was above 3.46, the average annual return over the next four years was -5.6% and was always negative.

Current Expected EM Returns High Than US

The bottom line is that, currently, expected returns among emerging market equities—particularly emerging market value stocks—are much higher than they are for U.S. stocks (as well as those in other developed markets, though to a lesser degree).

Of course, by no means are the higher expected returns a free lunch—they come with greater risks. That said, given that emerging markets now make up more than half of global GDP and about one-eighth of global equity capitalization, the starting point to consider is an emerging markets allocation of one-eighth of your equity allocation.

If you’re an investor who’s willing and able to accept more risk, you might consider a somewhat higher allocation, and vice versa. At any rate, your allocation should not look much different than the global market capitalization; otherwise, you’re betting against the collective wisdom of the market, a very tough competitor. That said, let’s examine the case for global diversification.

Making The Case For Global Diversification

Diversification rightly has been called the only free lunch in investing. A portfolio of global equity markets should be expected to produce a superior risk-adjusted return to any one country or region held in isolation.

However, the benefits of global diversification came under attack as a result of the financial crisis of 2008, when all risky assets suffered sharp price drops as their correlations rose toward one. When that happened, many investors surmised that global diversification doesn’t work because it fails when its benefits are needed most. That is wrong on two fronts.

First, the most critical lesson investors should have learned is that, because correlations of risky assets tend to rise toward one during systemic global crises, their portfolios should be sufficiently allocated to the safest bond investments (investments such as U.S. Treasury bonds, FDIC-insured CDs and municipal bonds rated AAA/AA). The overall portfolio should reflect one’s ability, willingness and need to take risk.

Flights To Liquidity

At the time they’re needed most, during systemic financial crises, the correlations of the safest bonds to stocks—which average about zero over the long term—tend to turn sharply negative. They benefit not only from flights to safety but also from flights to liquidity.

The second lesson many investors failed to understand is that, while international diversification doesn’t necessarily work in the short term, it does work eventually. This point was the focus of a paper by Clifford Asness, Roni Israelov and John Liew, “International Diversification Works (Eventually),” which appeared in the May/June 2011 edition of the Financial Analysts Journal.

The authors explained that those who focus on the fact that globally diversified portfolios don’t protect investors from short systematic crashes miss the greater point that investors whose planning horizon is long term (and it should be, or they shouldn’t be invested in stocks to begin with) should care more about long, drawn-out bear markets, which can be significantly more damaging to their wealth.

Don’t Let Short-Term Failures Blind You

In their study of 22 developed-market countries during the period 1950 through 2008, the authors examined the benefit of diversification over long-term holding periods. They found that, over the long run, markets don’t exhibit the same tendency to suffer or crash together. As a result, investors should not allow short-term failures to blind them to long-term benefits.

To demonstrate this point, the authors decomposed returns into two components: (1) those due to multiple expansions (or contractions), and (2) those due to economic performance.

Most Important Determinant Of Long-Run Returns

The authors found that while short-term stock returns tend to be dominated by the first component, long-term stock returns tend to be dominated by the second. They explained that these results “are consistent with the idea that a sharp decrease in investors’ risk appetite (i.e., a panic) can explain markets crashing at the same time. However, these risk aversion shocks seem to be a short-lived phenomenon. Over the long run, economic performance drives returns.”

They further showed that “countries exhibit significant idiosyncratic variation in long-run economic performance. Thus, country specific (not global) long-run economic performance is the most important determinant of long-run returns.”

For example, in terms of worst-case performances, the authors found that, at a one-month holding period, there was very little difference in performance between home-country portfolios and global portfolios.

However, as the horizon lengthened, the gap widened. The worst cases for the global portfolios are significantly better (the losses are much smaller) than the worst cases for the local portfolios. And the longer the horizon, the wider the gap is favoring the global portfolios.

Demonstrating the point that long-term returns are more about a country’s economic performance and that long-term economic performance is quite variable across countries, the authors found that “country specific economic performance dominates long-term performance, going from explaining about 1% of quarterly returns to 39% of 15-year returns and rising quite linearly in time.”


We live in a world where there are no accurate crystal balls. Thus, the prudent strategy is to build a globally diversified portfolio. But that’s simply the necessary condition for success. The sufficient condition for success—the second part—is to possess the discipline to stay the course, ignoring not only the clarion cries from those who think their crystal balls are reliable but also the cries from your own stomach to “Get me out!”

As Warren Buffett explained, “The most important quality for an investor is temperament, not intellect.”

To help you stay disciplined and avoid the consequences of the dreaded investment disease known as recency, I offer the following suggestion …

Whenever you are tempted to abandon your well-thought-out investment plan because of poor recent performance, ask yourself this question: “Having originally purchased and owned this asset when valuations were higher and expected returns were lower, does it make sense to now sell the same asset when valuations are currently much lower and expected returns are now much higher?” The answer should be obvious.

And if that’s not sufficient, remember Warren Buffett’s advice to never engage in market timing, but if you cannot resist the temptation, you should buy when others panic and sell.

Larry Swedroe, Director of Research

This commentary originally appeared March 24 on ETF.com
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