Diversify emerging-market exposure

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.

The challenge facing investors is that while economic growth is certainly important for equity investors, they’re not compensated for investing on the basis of economic growth that’s expected, and therefore priced into financial markets. Because outperformance is more dependent on unexpected growth, investors must be able to accurately predict unexpected growth—an extremely difficult task.

While valuations have been an important factor in evaluating future performance in developed markets (such as Canada), the relationship between initial P/E ratios and subsequent returns breaks down when we extend it to individual emerging markets. We clearly see that low initial P/E ratios have not signified higher subsequent returns, nor have high initial P/E ratios led to low subsequent returns.

The key difference among individual emerging markets in terms of the relationship between valuations and return is idiosyncratic, or country-specific, risk.

From December 2004 to October 2006, the Venezuelan stock market was valued at less than 10 times earnings. Historically, such a low valuation would be a strong indicator of above-average future performance for a diversified, developed market such as Canada.

But for emerging markets, valuation ratios could be low because of expectations of slower future earnings growth. In the case of Venezuela, geopolitical risks prevailed, and it was removed from the public investment space as its government seized private assets and foreign capital, thus making the potentially attractive P/E multiple meaningless.

Diversification is critical

This evidence suggests accurately selecting an emerging-market country that will outperform is difficult, at best. At worst, an investor or advisor can experience significant volatility, higher costs, underperformance, and the potential for nonmarket risks. As with most concentrated and volatile asset classes or strategies, the risk of getting it wrong can far outweigh the gains from getting it right.

The message is simple. When advising your clients on emerging markets, diversification is the critical factor. For a greater chance of success, investors have found broad-market ETFs to be their most reliable tools.

Atul Tiwari is managing director, Vanguard Investments Canada.