Consultants and academics are warning against diving too deeply into emerging markets equity.
A recent report by Elroy Dimson, Paul Marsh and Mike Staunton, finance professors at London Business School, said outsized performance won't likely continue, diversification benefits have weakened and economic growth in emerging economies might not lead to superior stock returns.
As part of the annual “Credit Suisse Global Investment Returns Yearbook 2010,” the professors predict that emerging equity markets' annual outperformance vs. developed markets will be more like 1.5 percentage points going forward.
In comparison, emerging markets delivered annualized 10% returns vs. roughly zero for developed markets for the 10 years ended Dec. 31.
(In 2009, the Standard & Poor's Emerging Plus Broad Market index returned 82.5%, nearly twice the 44.8% of the Morgan Stanley Capital International World index of global developed markets.)
Surging performance, diversification benefits and expectations of economic growth in developing countries have driven institutional investors to increase allocations to emerging markets equity (Pensions & Investments, Nov. 2).
But investor expectations tying economic growth to stock performance is misplaced, according to the professors.
“This higher return (vs. developed markets going forward) arises not from the spurious growth argument, but from a financial argument as old as time, namely that investors require higher returns for higher risk,” they stated in the report.
Looking at performance data since 1976, the professors warned that not all emerging economies have grown faster than developed markets, and that any implications of faster economic growth in emerging markets will already have been priced into those markets.
In an interview, Mr. Marsh made clear that he and his co-authors aren't saying emerging market equities should be shunned; they are becoming too significant to be ignored and will continue to provide diversification and outperformance in equity portfolios. However, “we're sounding a cautionary note,” he said.
Investment consultants have mixed views on whether long-term return expectations of emerging market equity have shrunk vs. global developed equity.
Hewitt Associates projected emerging markets' average annual outperformance to be 1.1 percentage points as of Dec. 31, down from 2.3 percentage points as of Sept. 30, 2008. Rogerscasey Inc., however, is projecting outperformance of 3.1 percentage points, up from 2.8 percentage points in 2009. That widening gap was caused by a lower outlook for developed markets; the firm's outlook for emerging markets held steady.
“That does not mean we won't have bumps in the road (in emerging markets equity returns), but we think fundamental growth and domestic demand will lead to better stability for many of the emerging markets over the next decade,” Cynthia Steer, chief research strategist at Rogerscasey, Darien, Conn., wrote in an e-mail response to questions.