Do Emerging Market Funds Belong In Your Portfolio?

The 20th century was America’s century.  In 1900, the United States was the China of its day.  The world’s economic powerhouse of the time, Great Britain, was just beginning its long, slow relative decline, with America picking up most of the slack. In today’s parlance, Great Britain was the developed nation and the United States a mere emerging market (or less-developed country).  America was full of untapped potential

After over 100 years, the tables have finally turned.  It is the United States that now sits at the top of the heap.  Much of the untapped economic potential that so characterized the American Century has been exploited.  That’s not to say there are no opportunities left, far from it!, but most of the low-hanging fruit has already been harvested.  There is a Starbucks or McDonalds on every street corner around the world.  Coca-Cola is the second most-recognized word in the world, second only to “okay.”  The world has been conquered, economically speaking.  There is literally nowhere to go but down.

The Case For Emerging Market Funds

Today’s emerging markets are the super-powers of the future.  The economies of China (particularly China), India, Brazil, and Russia will become increasingly more important as time goes on.  Clearly, the U.S.-centric investing strategy of the past few decades is no longer tenable.  The mean recommended international stock allocation has steadily increased from basically 0% in the 1950’s to between 20-25% today, and rising.  Emerging market funds offer investors a piece of the high-growth, developing-economy pie.  While America is unlikely to actually decline in absolute terms, it will amost certainly gobble up less of the global economic pie over the next 50 years than the last 50 years.  A Great-Britain-like fate isn’t all that bad, but it does mean the U.S. stock returns aren’t likely to lead the world going forward.

How Much In Emerging Market Funds Is Enough?

Clearly, emerging market funds belong in everybody’s portfolio.  But how much is enough?  By all accounts, roughly 18-20% of the total global market cap is in emerging markets, making that a good starting point.  But there are other considerations.  More important than achieving a market-cap weighted equity allocation, in my opinion, is figuring out how much risk you are willing and able to take and allocating accordingly.  For some, an 18% allocation to emerging market funds may be far too much to stomach.  For others, it may be too little; however, I would caution against going too far above their natural market weight for a few reasons.  My own retirement portfolio reflects the market weight, more or less.

• Higher Risk Does Not Equal Higher Returns – Higher risk equals the potential for higher returns.  They are far from guaranteed.
• Emerging Market Stocks Have High Valuations – Since the high growth potential of emerging markets is no secret,  the market has to a large extent already eliminated the possibility of out-sized future returns by bidding up the holdings of most emerging market funds in advance.

Advantages Of Emerging Market Funds

As an asset class, emerging market funds have a few distinguishing characteristic that makes them very desirable from a diversification standpoint.

• Low Correlation To Developed Markets – While developed markets have become increasingly coupled of late, emerging markets seems to have resisted this trend somewhat.  Emerging market funds still tend to zig when U.S. markets zag, making them valuable diversifiers.
• High Potential Returns – Emerging market funds have the potential to deliver huge returns over the long term.  It’s true the market has already priced in high growth rates and there’s a lot of risk involved, but you’ve still got a better chance at earning high returns in emerging markets than domestically.
• Diversification – Even if you don’t think emerging market funds will beat domestic funds over the next 50 years (I’m sure such people exist), it still makes sense to hold them if only for diversification’s sake.  Two asset classes are better than one.