Advisors Should Pay Cautious Heed to Emerging Markets

Midway through 2017, emerging markets are outperforming the S&P 500, the Russell 2000 and the MSCI EAFE indexes.

But before advisors set sail for overseas markets, analysts warn caution. This crop of ETF winners also carry their fair share of risk, maybe too much risk, especially in single-country ETFs.

By the numbers, emerging markets are roaring this year. The benchmark MSCI EM index stands at over $1,000, price-wise, as of June 1. The index is up 25 percent on a year-to-year basis, rising 150 points since December 2016.

On an individual basis, First Trust Chindia ETF (FNI) leads the pack, up 27.75 percent on a year-to-date basis, as the two main Asian Tiger countries continue to show strength. The Columbia Beyond BRICs ETF (BBRC) is also humming, with a year-to-date return of 15 percent through the end of May.

On the downside, Latin American country funds are getting decimated, with the benchmark Latin America 40 ETF (ILF), down 84 percent. Europe-themed ETFs are down, too, by 15 percent for the year.

Yet, ask a professional Wall Street observer and you could well get a lecture on why evaluating current market conditions with emerging market funds isn’t a good strategy. While you’re at it, don’t put too much stock in rates of return if you don’t cover a few key risk factors.

“Emerging market exposure should be a consistent strategy for investors, and not one predicated on current market conditions,” said Robert Johnson, president and CEO of The American College of Financial Services, a non-profit, accredited institution based in Bryn Mawr, Pa.

According to Johnson, the two major advantages of emerging markets are higher potential stock returns than in developed markets and their relatively low correlation with those markets.

“From 1988 through 2013, a broad emerging markets index had a mean annual return of 14 percent,” Johnson said, citing data from the 2015 book “Invest With the Fed” that he helped write. “Over that same time period, the S&P 500 had a mean annual return of 10.5 percent.”

Greater Volatility

Yet while the emerging market index had a higher return, it also had greater volatility over that time period.

“The broad emerging market index had a standard deviation of 23.7 percent annually and the S&P 500 had a standard deviation of 18.3 percent,” Johnson said. “Over that same time period, the correlation between the emerging markets index and the S&P 500 was 0.66.”

Emerging markets “look attractive for a couple different reasons,” Johnson added, mainly due to valuation levels and the path of expected future interest rates.

“Emerging markets indices sell at a deep discount to the broad U.S. market,” he explained. “While the S&P 500 is selling for roughly 20 times earnings, emerging market funds are selling at closer to 12.5 times earnings. From a value standpoint, there looks to be more margin of safety in emerging markets.”

Interest-rate trends factor into emerging market fund returns as well.

“From 1988 through 2013, emerging markets provided a robust 16.5 percent return in rising interest rate environments, while only returning 8.4 percent in falling rate environments,” Johnson said. “This is exactly the opposite pattern we found in U.S. stocks, as from 1966 through 2013, the S&P 500 returned 15 percent when rates were falling and only six percent when rates were rising.

“With most analysts predicting a rising rate environment, emerging market equities are poised to perform well,” he added.

Investors should diversify their holdings across emerging markets, Johnson recommended.

“Some broad emerging market index funds such as the Vanguard Emerging Markets Stock Index Fund Investor Shares (VEIEX) are appropriate,” he said. “The fund is well diversified across several emerging markets and has an expense ratio of 0.32 percent, compared to the average expense ratio of similar funds which stands at 1.46 percent.”

Going the “single country” route is just too risky with emerging market ETFs.

“The bottom line is that individual emerging markets can be quite volatile as we have seen recently with Brazil,” Johnson said.

A recent corruption scandal in the Brazilian government led to enormous one-day losses in Brazilian stocks and funds. The iShares MSCI Brazil fund (EWZ) lost 16 percent on May 18.

“Investors would be wise to diversify across markets, either by purchasing several country emerging market funds, or by holding a fund that broadly diversifies across the globe,” Johnson said.

Never More Than 5 Percent

For advisors looking for a percentage range with emerging market portfolio investments,
Ben Westerman, a money manager with HM Capital Management in Clayton, Mo. provides some guidance.

“As a general rule, we invest a portion of client stock allocation to international equities. The usual starting point is 15 percent,” Westerman said. “Of that 15 percent, roughly 20 percent is in emerging markets. This brings the total exposure to emerging markets of about 3 percent of the overall stock portfolio.”

Westerman would not invest more than 5 percent of a client’s overall investment in emerging markets. Also, be prepared to go through cycles of five-to-seven years where emerging markets will underperform the S&P 500.

Overall, emerging markets are the place to be in 2017, as long as investors stay diversified, keep an eye on rates, and cap their portfolio allotment to five percent, as Westerman advised.

Do that and watch your clients benefit from having a well-travelled investment portfolio.

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms, including CBS News, The Street.com, and Bloomberg. Brian may be contacted at brian.oconnell@innfeedback.com.

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