Emerging markets seem to have lost their lustre. The larger countries such as China, India and Russia are experiencing slowing economic growth. The commodity-oriented countries, particularly the ones in Latin America, are adjusting to a new normal after tailwinds from a decade of rising commodity prices have ebbed. Market returns in emerging markets have also moderated since the years leading up to the 2008 global financial crisis. From 2003 to 2007, the MSCI Emerging Markets Index (in Canadian dollars) posted an annualized return of 25%. Over the last three years, that return has fallen to a mere 1%.
There is also a perception that correlations across asset classes are higher relative to about a decade ago. This was clear in 2008 when almost all major equity markets around the world fell sharply. One reason for rising correlations has been globalization, where many of the largest firms in Europe and the United States -- such as 
HSBC HSBC and Citigroup C, and GlaxoSmithKline GSK and Merck MRK -- are actually more similar than different as they compete with each other across the globe.
Another reason has been the liberalization of capital markets in developing countries, which has resulted in greater foreign investor participation in local equity and debt markets. With greater foreign participation, these developing countries are now more susceptible to volatility originating in the developed markets. For example, in the summer of 2013, after the U.S. Federal Reserve indicated that it would begin to scale back its asset purchase program, countries with weaker economic fundamentals, such as Indonesia, India and Thailand, saw declines of around 20% (in U.S. dollar terms, from June through August) due in large part to heavy foreign fund outflows. In the few years prior to 2013, these markets had been relative outperformers and had seen strong foreign fund inflows.
Correlations are no longer on an upward trend
Correlations between the MSCI Emerging Markets Index (in CAD) and the S&P/TSX Composite were on an upward trend in the 1990s (see Figure 1). However, it is important to note that emerging markets weren't always so accessible. MSCI's emerging markets benchmark was only created in 1988, and in the early years emerging-markets stocks did not garner broad investment interest due to a series of crises -- hyperinflation in Brazil, the Mexican peso crisis in 1995, the Asian financial crisis in 1997 and Russia's debt default in 1998. But once emerging markets started to generate double-digit returns in the early 2000s, foreign funds began to pour into the asset class.
Figure 1: Correlation of MSCI Emerging Markets to S&P/TSX Composite
Source: Morningstar Direct
But over the last 15 years, correlations are no longer on an upward trajectory and generally have remained within a range of 65% to 85%, at an average of 75%. While correlations do tend to rise after certain events (escalating eurozone crisis, Fed taper, global financial crisis), these periods tend to be short-term in nature. Over the long term, since emerging market companies generally have different fundamentals and are exposed to different market conditions, relative to Canadian companies, an allocation in a developing-markets fund should provide some diversification benefits.
Portfolio diversification in action
To assess the diversification benefits of an emerging markets allocation, we created two diversified portfolios: Model 1 with no emerging markets exposure, and Model 2 with a 10% emerging markets allocation. The MSCI indexes are market cap-weighted indexes that include large- and mid-cap stocks.
| Index | Model 1 | Model 2 | ||
 |
||||
|
||||
| Canadian equities | S&P/TSX Composite | 40% | 40% | |
| U.S. equities | MSCI USA Index | 40% | 40% | |
| Intl developed | MSCI EAFE Index | 20% | 10% | |
| Emerging markets | MSCI EM Index | 0% | 10% | |
|
||||
As we can see in the table below, a diversified portfolio with and without an emerging markets allocation does result in reduced volatility (as measured by the annualized monthly standard deviation of returns), relative to the S&P/TSX Composite. And during the worst of the 2008 financial crisis, a diversified portfolio resulted in more muted declines.
| Model 1 | Model 2 | S&P/TSX Composite | |||
|
|||||
|
|||||
| Standard deviation 15 yr | 12% | 13% | 15% | ||
| Standard deviation 10 yr | 11% | 11% | 14% | ||
| Worst 3-mo (to Nov. 30, 2008) | -25% | -26% | -31% | ||
|
|||||
| *As of May 26, 2014 Source: Morningstar Direct |
|||||
|
|||||
Although adding an emerging markets allocation can result in slightly more volatility (relative to a diversified portfolio without an emerging markets allocation) emerging markets may offer the potential for more upside. Over the last 10 and 15 years, Model 1 generated higher risk-adjusted returns (as measured by the Sortino Ratio) relative to Model 2. However, over that period, Canadian stocks outperformed both models, thanks to two very favourable market environments over the last decade -- rising oil prices, followed by a strong housing market, which buoyed the large-cap energy stocks and financials stocks that dominate the S&P/TSX index.
| Model 1 | Model 2 | S&P/TSX Composite | |||
|
|||||
|
|||||
| Sortino ratio 15 yr | 0.37 | 0.41 | 0.54 | ||
| Sortino ratio 10 yr | 0.59 | 0.62 | 0.75 | ||
|
|||||
| *As of May 26, 2014 Source: Morningstar Direct |
|||||
|
|||||
Latin America vs. Asia
Within the emerging markets, Canadian investors tend to shy away from Latin American funds, partly because the investable universe of Latin American companies is tilted toward the material and energy sectors -- exposures that can be achieved by investing in Canadian natural resources companies. The correlation between Canadian and Latin American equities is higher than the correlation between Canadian and Asian equities, which suggests that a relatively large exposure to commodities may be a common factor between Canadian and Latin American securities. While the 2008 global market crash, followed by a commodity-driven rally thanks to China's aggressive stimulus program in 2009, resulted in a 90% correlation between the S&P/TSX Composite and Latin American equities, correlations have been trending down since then. In addition, in the decade leading up to 2008, correlations ranged from 60% to 75%, which is actually not very high.
Figure 2: Correlation of Asian and Latin American Equities to S&P/TSX Composite
Source: Morningstar Direct
Funds for emerging market exposure
Emerging market ETFs seem attractive relative to actively managed alternatives due to their lower fees. However, a market-cap-weighted exposure does have drawbacks in this area. First, these funds have a large exposure to government-controlled entities in China, Russia and Brazil -- firms that may put politics ahead of profitability. In addition, these funds also have heavy weightings in South Korean and Taiwanese consumer and technology firms that sell to a global marketplace, and therefore have less exposure to emerging market trends.
However, there are ETFs that track indexes that are not market cap-weighted, such as iShares MSCI Emerging Markets Minimum Volatility XMM. This fund tracks an index that selects about 200 stocks from its parent index (the MSCI Emerging Markets Index) to form a low-volatility portfolio. Low-volatility strategies seek to exploit the observed phenomenon that portfolios with smaller price fluctuations tend to outperform portfolios with larger price fluctuations over the long term. But, thanks in part to the heterogeneity of the emerging-markets equity asset class, low-volatility strategies in emerging markets have historically resulted in a greater reduction in portfolio volatility relative to a cap-weighted index than what has been observed in U.S. equities. In other words, there is more diversity (lower correlations) among emerging-markets equities, which allows for greater reduction in overall volatility in an emerging-markets low-volatility portfolio. In addition, this fund has less exposure to global cyclical and government-controlled entities, relative to the MSCI Emerging Markets Index. The MER for this fund is a relatively low 0.41%.
Among actively managed mutual funds, Morningstar currently has one analyst-rated (Silver) emerging markets fund -- Brandes Emerging Market Equity 
, which has outperformed its category average over the last five and 10 years on an annualized basis. The fund managers employ a deep-value strategy, but are careful to avoid the many value traps in emerging markets. As a result, this fund has a relative underweight in China due to its limited exposure to the large cap Chinese banks. At this time, the fund managers think these banks offer enough margin of safety, especially as China's financial regulatory environment continues to be fluid in the near and medium term. The fund has an overweight in telecoms and also holds a number of attractively-valued European telecom companies that have operations in the emerging markets. This fund carries an MER of 2.70%.
