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At Arm's Length: 08.04.04
>For over a month now, the bond markets have done what every other market has. They have taken the lead from the economy and begun to lower expectations that growth, or the gallop that growth once was, has slowed considerably. Each time I sat to write something about this event, a supposedly weekly ritual that was interrupted briefly by a vacation, there would be nothing to say that hasn't been written before.
Today's Commentary: 08.03.04
Emerging Markets: What Role, If Any, Should They Play in a Portfolio? Parts One and Two
by Larry Swedroe
Many investors shy away from investing in emerging markets because they are considered to be either highly risky investments or, even worse, pure speculations. The fact that the emerging markets are risky, however, should not preclude investors from considering allocating some portion of their portfolio to them.
In fact modern portfolio theory tells us that sometimes we can add risky assets to a portfolio and actually reduce the risk of the overall portfolio. Another reason to consider investing in emerging markets is that because it is a highly risky asset, an efficient market will appropriately price that risk. The result is higher expected returns. Thus if you believe that investing in emerging markets are highly risky, the logical conclusion you should draw is that an allocation to emerging markets boosts the expected return of the portfolio.
1. Emerging Markets Are Risky We begin our discussion on the role of emerging markets in portfolio construction by first considering why they are considered to be highly risky. One important measure of risk is volatility. Riskier assets generally experience greater price volatility. While data is only available for a relatively short period, we do observe that emerging markets have experienced high volatility.
For the period 19872003,1 the three DFA emerging markets portfolios, Emerging Markets, Emerging Markets Small, and Emerging Markets Value, experienced annual standard deviations of 34.2, 36.7, and 38.3, respectively. This compares to a standard deviation of "just" 15.8 for the S&P 500. So our first observation is that emerging markets are risky from the perspective of volatility, at least on a standalone basis. However, one of the cases made for investing in emerging markets is that they have low correlation to other asset classes. The low correlation might result in a lowering of the volatility of the overall portfolio. Let's examine the available data to see if this has been the case.
2. Is There Any Diversification Benefit? The good news is that the correlations of returns of the three DFA emerging market funds to the S&P 500 Index are all relatively low. For period 19872003, the correlations of the Emerging Markets, the Emerging Markets Small, and the Emerging Markets Value Funds to the S&P 500 Index were 0.597, 0.468, and 0.548, respectively. However, the bad news is that the impact of volatility swamped the diversification benefit. The result was that as you increased the allocation to emerging markets in the portfolio, you raised the standard deviation of the portfolio.
Once again we examine the period 19872003. For that period, a portfolio consisting of an allocation of 10 percent to the DFA Emerging Markets Fund and 90 percent to the S 500 Index produced a standard deviation of 17.8. This is significantly (12.6 percent) greater than the 15.8 standard deviation of the S&P 500 Index. As you increased the allocation to the emerging markets, the standard deviation of the portfolio also increased. The standard deviations of portfolios with an allocation of 20, 30, and 40 percent to the emerging markets were 18.2, 19.1, and 20.5, respectively.
The news is not, however, all bad. Keeping in mind that the data is available only for a very short period, the highly risky emerging markets have delivered significantly higher returns. While the S&P 500 Index returned 11.9 percent for the period 19872003, the DFA Emerging Markets, Emerging Markets Small, and Emerging Markets Value Funds returned 14.8, 20.0, and 20.7 percent, respectively.
3. Risk-Adjusted Returns We can also look at emerging markets from the perspective of how efficiently they delivered returns relative to the risk experienced. The Sharpe Ratio (the annual return minus the annual risk-free rate divided by the standard deviation of returns) measures the efficiency of return relative to risk.
Before considering the data on Sharpe Ratios, it is important to remember four key points. First, the data is for a very short time frame. Second, volatility is only one measure of risk, not the only one. Third, some investors care more about volatility (and the stomach acid it can create) than others. Fourth, while you can spend returns, you cannot spend Sharpe Ratios‹which is why some investors, while not ignoring volatility, place more emphasis on returns than on Sharpe Ratios. Let¹s look at the data.
For the period 19872003, the Sharpe Ratio for the S&P 500 Index was 0.47. For the DFA Emerging Markets, Emerging Markets Small, and Emerging Markets Value Funds the Sharpe Ratios were 0.42, 0.56, and 0.56, respectively. While the Emerging Markets Fund produced an 11 percent lower Sharpe Ratio, the other emerging market funds both produced Sharpe Ratios that were 19 percent higher. Let¹s now look at the Sharpe Ratios for a portfolio with various allocations to the emerging markets.
Here the news is even better. The diversification benefit (low correlation), combined with the higher returns, was more than sufficient to lead to an improvement in the Sharpe Ratio. We will examine the Sharpe Ratio for various allocations to the emerging markets. We will look at allocations that are from 90 percent S&P 500 Index/10 percent emerging markets to 60 percent S&P 500 Index/40 percent emerging markets. The data covers the same period 19872003. The benchmark is the Sharpe Ratio for the S&P 500 Index, which was 0.47. The following table shows the results for various allocations. It also shows the results from using the three different DFA emerging markets funds to gain the exposure to the asset class of emerging markets.
As you increased the allocation to emerging markets three things happened to the portfolio‹it became more volatile (riskier), the rate of return increased, and the efficiency of the portfolio (as seen in the Sharpe Ratio) in terms of delivering risk-adjusted returns rose (at least until you reached at least a 30 percent allocation to emerging markets). In every case the rate of return was greater than that achieved by the S&P 500 Index. And in every case the Sharpe Ratio was greater.
This is not to suggest that an investor consider allocating as much as a 40 percent to emerging markets. Investors care (or should care) about far more things than just high-expected returns and Sharpe Ratios. The purpose of this study was to demonstrate that while emerging markets are risky, they have provided higher returns and they have also improved the efficiency of a portfolio. Thus investors should at least consider allocating a portion of their equity holding to the asset class of emerging markets. Before deciding on what percent should be allocated investors should be fully aware of why investing in emerging markets is risky.
4. The Risks of Emerging Markets Investing
As we have seen, the historical evidence is that emerging markets are highly volatile. The high volatility alone scares off many investors. However, an asset class can be risky without exhibiting high volatility. For example, it just might be that the data is period specific, and the risk has just not showed up‹at least not yet. In the case of emerging markets, however, there are many risk factors that make investing in them intuitively risky. In other words, we would know they were risky even if their volatility had not been greater.
A general lack of a strong regulatory body (i.e., the SEC) to protect investor interests. "Mandatory disclosures make information that firms disclose more credible. As investors become better informed, the volatility of prices is reduced. In addition, the ability of better informed (insiders) but unscrupulous traders to take advantage of other investors is reduced." (Raghuram G. Rajan and Luigi Zingales, Saving Capitalism From the Capitalists, p160. )
A general lack of consistent accounting standards that give investors confidence in the accuracy of data. "Study after study has shown that better accounting standards help make firms more transparent, making it easier for them to inspire confidence in investors." (Ibid. p. 161) The lack of standards also leads to greater opaqueness of reporting of financial and other material information.
These first two issues are related to what we would call good corporate governance. There are, however, still other factors that should be considered.
Political risks‹Emerging market countries are often characterized by governments that are less stable than those of developed countries. There may also be a lack of a tradition of democratic government (if a democracy exists at all). Political risks can even include the potential for the expropriation of property.
Lack of strong financial markets‹Emerging markets often lack strong banking systems. Thus these markets often face financial crises when credit becomes very difficult, if not impossible, to obtain. This might explain why the value and especially the size premiums have been higher in the emerging markets than they have been in the developed markets.
Small and value companies not only have fewer choices in terms of raising capital, but as generally weaker credits (and often without assets that can be pledged as collateral) they are the first ones to be cut off from funding during any liquidity crises‹thus investors demand a risk premium. For the period 19872003, the size premium in the United States was 1.95 percent. In comparison, in the emerging markets the size premium was almost triple that figure.
The same is true of the size premium, which in the United States was 2.4 percent. It is also worth noting that when the United States was an emerging market it often faced banking and liquidity crises.
Currency risk‹the currencies of emerging markets countries are often highly volatile, contributing to the high volatility of returns of the asset class.
Default risk‹some emerging markets (i.e., Argentina, Brazil) have experienced episodes of default on their sovereign debt. Defaults, or even the potential for default, can create substantial volatility in the capital markets.
Risk of capital controls being put in place, preventing the repatriation of capital‹ This happened as recently as 1998 during what came to be known as the Asian Contagion.
Lower levels of market liquidity leading to higher trading costs. In addition, other transaction related fees (e.g., custodial fees, taxes) are also likely to be greater. According to Joshua Feuerman, manager of the SSgA (State Street Global Advisors) Emerging Markets Fund, a round-trip purchase and sale of a block of stock in a typical emerging market costs about 4.5 percent of the value of the stock. "It¹s a disgustingly expensive asset class to trade in." (New York Times, January 24, 1999) Lower levels of liquidity and greater trading costs create more risk, for which investors seek compensation via lower prices.
It is important to note that while some of these risks (i.e., political risk) can be diversified by owning a mutual fund that invests in many emerging market countries, not all the risk is diversifiable. Thus, as we have discussed, investors must be compensated for taking this nondiversifiable risk with a higher expected return. The markets have in fact delivered those higher returns; but only if investors had the discipline to stay the course.
A great illustration of this point is that the DFA Emerging Market Fund, while outperforming the S&P 500 Index by almost 3 percent per annum over the seventeen years from 1987 through 2003, provided negative returns for the nine-year period beginning in 1994. (The only time this happened to the S&P 500 Index was during the Great Depression.) Similarly, the DFA Emerging Markets Small Fund provided negative returns for the eight-year period beginning in 1995. The longest period of negative returns for the DFA Emerging Markets Value Fund was the five-year period beginning in 1994.
The result of the high volatility and long periods of poor performance is that emerging markets are characterized by not only extreme volatility of prices, but also by extreme volatility of enthusiasm for investing in them.
Thus perhaps the biggest risk to investors in emerging markets is the risk of not being there. Far too many investors get chased out of the asset class when times are bad. And there are always good arguments about why investing in emerging markets is a bad idea, and why investors never should have invested in them in the first place. Thus only those with extreme discipline should even consider investing. To paraphrase Charles Ellis, author of the wonderful book, Investment Policy: Emerging market "investors would do well to learn from deer hunters and fishermen who know the importance of ³being there² and using patient persistence‹so they are there when opportunity knocks."
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