Morningstar - Fall 2019 - 12

Dispatches

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.
While emerging-markets stocks certainly could
outperform over the next few years-always
the danger when taking a stance against an asset
class-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.
Bad Timing?
When I originally made this pronouncement in
my Morningstar.com column, several readers
responded that emerging-markets shares
haven't lagged solely because their companies
have disappointed. They also have been
discounted. Whereas emerging-markets equities
once commanded relatively high price/earnings
multiples, they now sell for less than developedmarkets stocks-particularly those of the
United States.

Meaning that my article might have been
a contrarian signal. When an asset performs so
poorly that even Rekenthaler notices, that
could be because the investment has hit rock
bottom, with nowhere to go but up.
There's something to that idea, although it is far
from foolproof. For example, contradicting this

12

Morningstar Fall 2019

column's implied advice by buying managedfutures funds in 2013, or swapping growth for
value stocks in 2015, would have been
unhelpful. But it's true that historical performance
analysis runs the danger of being ill-timed.
Some of the best buys are assets that indisputably
were worthless.

made 6.5% annually. Or you could have placed it
all into high-yield bond funds-and made
6.5% annually. Two paths leading to the same
place. High-yield bond funds are perfectly
acceptable, but they don't belong in assetallocation schemes when they can readily be
duplicated by using basic asset classes.

(And emerging-markets stocks have indeed
been useless. A reader tested 11 different asset
allocations over the 31-year period from 1988
through 2019, for a two-investment portfolio
made up of the MSCI USA Index and the MSCI
Emerging Markets Index. The 100% USA
allocation scored the highest Sharpe ratio. Each
dollop of emerging-markets stocks reduced
the ratio, with the worst result being for 100%
emerging markets.)

The argument is different for emerging-markets
stocks. In their defense, one cannot get similar
investment results by combining other assets.
Emerging-markets stocks do provide something
special. However, while possessing unique
performance is a necessary condition for an asset
class, it is not sufficient. There must also be
an internal logic-an economic reason to justify
occupying the spot.

Color me neutral. Sometimes, I criticize investments
because they will not earn their keep. This is not
one of those occasions. Emerging-markets
equities have major drawbacks, but they also enjoy
genuine business opportunities. In that, they
do not resemble market-neutral funds, which carry
an expected return of Treasury bills minus
expenses-meaning, pretty much nothing. Over
time, emerging-markets equities should record
significantly positive returns.
I just don't think that is enough to justify treating
emerging markets as a distinct asset class.
There are 136 Morningstar Categories for funds
(including exchange-traded funds). Of those
136 categories, only two are commonly given their
own slots in asset-allocation models: highyield bonds and emerging-markets equities. By
contrast, others are funneled with similar
categories into a broader asset-allocation slot, as
with large-company U.S. stocks. Some fund
categories, such as convertible bonds, correspond
with no obvious asset-allocation slot at all.
The privilege should be revoked for both high-yield
bonds and emerging-markets equities.
High-yield bonds behave like a blend of value-style
U.S. stocks and intermediate-term bonds. Over
the trailing three years, you could have formed a
portfolio made up of 50% large-value stock
funds and 50% intermediate-term bond funds and

Reallocating
I don't see it. Consider India. It is true that
India's economy is not fully correlated with other
countries', that the Indian currency moves
on its own, and that many Indian companies
operate predominantly within their home
country. All these things give Indian stocks their
own rhythm. But being different is not
enough. Indian equities are but a fraction
of the global equity markets. For U.S. investors-
the Indian investor's needs are different-
the Indian stock market is too small to warrant
the attention.

The emerging markets overall are larger, so that
emerging-markets stocks account for 5% of
the global financial-assets market. (They account
for 20% of non-U.S. stock assets, which in turn
make up about half the global stock market-the
U.S., of course, possessing the other half. That
cuts their weighting to 10%, which is halved again
when fixed-income investments are considered.)
That might be enough for an asset class.
However, when bundling the various emergingmarkets countries into a single package, the
performance characteristics become blurred. India
moves, to an extent, on its own cycle; as does
China; as does Russia; as does Brazil. Place them
together, though, and their aggregate returns
start to resemble the rest of the world's.
The packaging mutes the national idiosyncrasies.
The result is something that, increasingly,
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