Emerging markets: tearing up the economics text books

The more risk you take on the greater your reward should be, but ten years of emerging markets investing suggests otherwise. Does the rule book need to be re-written? IG Portfolio Manager, Oliver Smith, takes a closer look.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
Emerging markets

Conventional economic wisdom suggests that, in the long term, investors should be compensated for taking on risk, generating excess returns over and above the risk free rate (cash). In our 2017 investment review we wrote about this and included a chart which showed that equity returns had been greater than fixed income returns, but investors had taken on more risk to benefit from them.

‘Risk be damned’, you might think, ‘surely seeking the riskiest asset class and owning it should be a shortcut to early retirement?’ — while this is what the text books tell us, unfortunately events often conspire to make this theory a deeply unprofitable one over extended periods of time.

Individual countries within emerging markets are an excellent example of where theory runs into cold reality.

Over the past ten years — a meaningful timeframe — we chart the annualised returns vs. risk for the majority of countries within the emerging markets index, excluding a handful of tiny ones with very small and inaccessible markets. The chart shows a wide divergence in performance between them; coming out top at an annualised return of 13.9% (a total ten year return of 267%) is Thailand, while Brazil has been particularly poor losing an average of -2.1% a year.

Chart 1: a decade of GBP emerging markets returns

Source: MSCI, IG Group, July 2018

The dotted trend line on the graph stands in contrast to investment theory. Increased risk has actually resulted in lower returns for investors, but we can still see the advantages of diversification. The MSCI Emerging Markets Index (the red dot) has recorded the second least volatile return, proof that holding a number of lowly correlated asset classes can improve your risk adjusted performance.

When looking at data, it always make sense to plot more than one graph as the numbers in Chart 1 could have been an anomaly caused be the financial crisis of 2008. Chart 2 shows this not to be the case — both Brazilian and Malaysian equity markets suffered large early declines, whereas Brazil has gone nowhere since 2010, the Malaysian market has made strong returns, up 150%. It has done this with less than half the volatility experienced by a Brazilian investor.

Chart 2: the tortoise beats the hare

Source: MSCI, IG Group, July 2018

Chart 1 is not designed to offer predictive powers for the future, there being many variables that drive share prices, but it does show that caution is needed before investing in asset classes that you don’t understand.

Investment managers are paid to take these decisions for you. Taking IG Smart Portfolios as an example, they are constructed with a strong focus on risk and the changing correlations between asset classes, but crucially they also use well researched Capital Market Assumptions (CMAs). We want to know how markets might perform in the future.

Alongside historic returns, CMAs are devised by looking at valuations (both current and historic ranges), earnings growth, political stability and economic momentum. Assessing which markets offer the best chance of a future return, rather than looking at which market have made the greatest returns, is the key to successful long-term investing.

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