Note: This article is part of Morningstar Canada's Emerging Markets Week Special Report
Rookie love
In the early 1990s, emerging-markets stock funds were the rage. Their subsequent results have been weaker than even the skeptics believed.
The appeal was obvious. Higher risk, according to conventional theory, meant higher returns--and there was no doubt that emerging markets carried higher risk. They also offered excellent growth prospects. The Asian Miracle was a catchphrase. South Korea, to name one example, had increased its per-capita gross domestic product from US$158 (expressed in current terms) in 1960 to US$6,516 in 1990. From behind Zambia to ahead of Turkey!
And, surely, those income gains would lead to investment success. Investors bought domestic emerging-growth stock funds--also named "emerging," also possessing higher risk--because eventually, their top-line expansion would lead to larger profits, which in turn would boost their share prices. The same logic applied to the institutional darlings, private equity and venture capital funds.
The argument made sense to many, your author included. The second fund I ever bought was Morgan Stanley Asia-Pacific, which, ahem, no longer exists, having been merged earlier this year into a sibling portfolio. (Haplessly, I still own those shares, despite a quarter century of failure.) I was not alone. Mutual fund companies rushed emerging-markets funds to the marketplace, where they were embraced by both financial advisors and adventuresome (foolish) direct investors.
Serious business
This wasn't one of those gimmick launches, as with short-term multimarket income funds or the tactical-allocation funds that arose from Black Monday's ashes. (Two decades later, tactical-allocation funds would again be hatched, after yet another market meltdown, and the second generation fared no better than the first. Beware funds that are created to fight the previous year's war.) The top organizations started emerging-markets funds. Fidelity did. T. Rowe Price did. DFA did. Even stodgy Vanguard did.
That the serious companies gave their assent signaled that emerging-markets funds were not another flavor of sector fund, designed only for those with particular tastes. They were for every risk-seeking investor. They were an asset class. The materials accompanying emerging-markets funds explained how they not only could be expected to outgain their developed-markets rivals over time but would also offer diversification. The economic cycles for emerging countries would not necessarily match those of the developed world.
Hmmm.
Help wanted
The latter claim was partially correct. On paper, emerging-markets stock funds did do some zigging while U.S. equities zagged. Unfortunately, it was useless diversification. The only two times during the GREAT BULL MARKET (the results warrant the capitalization) in which U.S. equity investors needed protection was the New Era technology-stock meltdown and, of course, 2008. Emerging-markets stocks dropped 25% during the first instance--better than the S&P 500 but roughly in line with Vanguard Value Index (VIVAX)--and crashed even harder during the second. There was no zigging; only zagging. The main reason that the correlation statistic is modest was because emerging-markets stocks nosedived during the mid-90s, when U.S. equities were booming. Great. If you seek diversification with something that heads south when the rest of your portfolio is thriving, and that goes down along with everything else when the bear market arrives, then emerging-markets stock funds are the asset class for you.
Emerging markets did have one stretch, during the aughts, when they behaved according to plan. Developed-markets stocks rose moderately, while emerging-markets stocks soared. That was the idea--to turbocharge portfolios during the good times. Finally, the original promise was realized.
Lagging far behind
One five-year stretch does not a quarter century make, though. A US$10,000 investment in Vanguard's emerging-markets stock fund at its 1994 launch would now be worth $47,000. Buying an S&P 500 index fund instead would have yielded just over $100,000. Emerging-markets funds were intended to bring greater rewards, over the long haul, and they have not done that.
The problem has not been GDP growth, nor changes in per-capita income. At last report, South Korea's citizens earned just under $30,000 per year--higher than the Spanish. The giant emerging countries of China and India have progressed even more dramatically. By and large, the emerging markets have prospered, just as the fund marketers said they would.
However, national growth does not neatly translate into corporate profitability. Emerging-markets countries are making more things, delivering more services, consuming more wares. Monies are being spent. But much of that cash does not make it to shareholders. It is squandered on profitless corporate expansions (empire building); or placed into government officials' pockets; or siphoned off to a CEO's friends and family.
The lesson of emerging-markets stock funds: Corporate governance matters, greatly. That topic received little attention when the funds were begun, but it ultimately proved to be the most important aspect of their future performance.
Moving forward
What's next? While emerging-markets stocks certainly could outperform over the next few years--always the danger when writing such a column--they do not merit being treated as an asset class. Their diversification benefits appear to be dwindling, as the emerging countries become larger and ever-more entwined with the global economy, and their expected returns are suspect. It is not clear that buying a package of stocks from countries labeled as "emerging" makes more sense than, say, buying one from countries whose names begin with the letter B.
Best to let the professional managers make the decisions. They can incorporate companies from emerging markets as they see fit--greatly, modestly, or not at all, depending upon how their funds are defined and (for actively managed portfolios) their views on the trade-off between 1) higher-growth opportunities and 2) stronger corporate governance. The experiment was tried, and it failed. It's time for a different approach.
