It seems like a great idea. Pick an emerging market you believe in; to get the biggest bang for your buck, invest in a single country ETF to get exposure to that emerging market; then watch the returns roll in.
There’s just one problem. Investing in a single emerging market carries enormous risk.
From 1988 to 2010, the range of annual returns of the countries comprising the MSCI Emerging >Market Index was as high as800% and as low as -80%. An investor who correctly picked the top-performing countries could have significantly outpaced the broad global market.
Of course, investors might have instead selected the country or countries that significantly underperformed. And in emerging markets, the difference between the winning countries and the losing can be stark.
For example, at the end of 2010, within the MSCI Emerging Markets Index, Thailand finished up more than 50%, while Poland finished down more than 10%. This can mean significant volatility for portfolios focused on country selection.
Difficult to pick the right country
Selecting individual emerging market countries can be much less efficient than investing in a broad market index. Stocks from individual countries have generally exhibited greater volatility without compensating investors with high returns.
From 1993 through 2010, the MSCI Emerging Markets Index delivered a combination of risk and return that exceeded the risk-adjusted performance of most of the individual countries in the index. Although five countries offered proportionately higher risk-adjusted returns, only one country (Chile) had volatility that was lower than that of the broad market (see “A Broad Emerging Markets Index Offers Efficiencies in Risk and Return,” below).
A Broad Emerging Markets Index Offers Efficiencies in Risk and Return
Source: Vanguard, MSCI, and Thompson Reuters Datastream
To realize the lower average volatility, investors would’ve had to invest in Chile for the entire period without adjusting allocations. So can countries with superior risk-adjusted returns be selected in advance—and then held in a strategic allocation across both good and bad markets? To answer that, we have to look at how investors evaluate equity market opportunities.
Common equity market metrics
Two common equity market metrics are valuation and economic growth rates. However, our research shows these metrics have not worked consistently when selecting emerging-market investment opportunities.
In fact, there is no correlation between realized economic performance and emerging-market returns. The correlation between long-run economic growth (as measured by real GDP growth per capita), and long-run stock returns across emerging markets has been zero.