Last November, we wrote about why the 3-D’s—deficit, debt, and demographics—are leading to structural headwinds for most developed markets, including the United States. In that issue of Fundamentals we suggested that U.S. investors should move from a U.S.-centric worldview and consider a larger allocation to emerging market economies because they don’t face a 3-D Hurricane: with few exceptions, they have modest deficits, manageable net debts, and they’re not about to hit a wall of prospective retirees (apart from China, which hits the retiree wall a few years after we do). But any old salt can tell you that there’s still work to do even when sailing with the wind at your back.
Many investors may not have invested more in emerging markets in part because of the relatively poor long-term performance of emerging markets as measured by the traditional emerging market indexes. It is true that capitalization-weighted emerging market equity investors have been poorly compensated for bearing extraordinary risks. They’ve enjoyed no risk premium and no reward for helping these economies to emerge!
The Fundamental Index™ strategy, however, has historically delivered an excess return fully consistent with the spectacular economic and likely future economic success of the emerging markets. In this issue we delve deeper into why economic performance did not (seem to) translate into returns for emerging market equity investors. We also show how changing your frame of reference from capitalization weighting to economic size weighting changes the picture.
Say What? The Emerging Growth Miracle and an Excess Return of Negative 2%?!1
Unquestionably, emerging markets have undergone a tremendous transformation since the mid-1990s. Despite some fits and starts, these economies have nearly doubled relative to the developed world, going from 18% of the world’s GDP in 1994 to 31% by 2009 according to the International Monetary Fund, even as developed economies’ anemic growth drove them from 82% to 69% of world GDP.
But if you are talking about the stock market, sorry. Emerging market equities were far from impressive, posting a per annum gain of 6.4% from 1994 through 2009. This ranks 10th among the oft-cited 16 asset classes that form the core of our GTAA work and even trailed the S&P 500 Index (whose Lost Decade weighed heavily on this measurement period).2 Relative to the applicable short-term debt available in these countries, the story is even bleaker. The J.P. Morgan Emerging Local Markets Index, which measures the results of money market sovereign debt in the local currencies, returned 8.3% per annum. U.S.-based emerging markets cash investors got a whopping 200 bps of excess return above their stock markets, even as their economies soared!
Where’s the reward for funding the enterprises at the heart of the emerging markets growth miracle? For that matter, where’s the reward for enduring 27% annual volatility and 11 drawdowns of 15% or more in just 15 years?
How Did This Happen?
We believe the gap between emerging market economic and stock market performance is a direct result of the return drag from capitalization weighting. How so? Consider the composition of these stock markets. Often, one, two, or at most a handful of stocks dominate the local individual emerging markets. These stocks get much of the flows from foreign investors seeking a liquid manner to access the local market, usually with some degree of name brand recognition.3 These top dogs are the most beloved, the most liquid, the best connected, the best respected, and the most recognizable—particularly for global equity investors seeking a toe-in-the-water investment in emerging markets. They are also the most expensive. Their popularity translates into a very large market capitalization that often dominates their local exchange as seen in Figure 1.