How Much Should We Invest In Emerging Markets – Burton Malkiel
One of the most enduring and perplexing behavioral biases in investing is called “The Home Country Bias.” Despite the availability of well-regarded and highly profitable corporations located through the world, investors have tended to limit their investments to companies domiciled in their own country. At one time, a survey of institutional investors in France found that 97 percent of their equity investments consisted of French companies despite the fact that France represented only 3 percent of the world’s total equity capitalization. There is a strong tendency for investors to regard international stocks as risky, and this is especially the case when it comes to emerging markets.
Emerging markets do indeed present additional risks, but they are less risky than they used to be. Many investors still remember the dramatic crisis in 1998, and the terrible losses suffered by equity investors as P/E multiples compressed to low single-digit levels. I certainly remember it; in fact, I co-authored a book on emerging markets that year called “Global Bargain Hunting.” Investors hoping for a repeat episode of 1998 are likely to be disappointed, however. A lot of corrective action was taken by governments everywhere at the time, and their economies and capital markets have progressed a great deal since then. A similar crisis is unlikely today.
While most investors are aware that these markets are growing, few realize just how large they have already become. It also pays to remember that, within a global stock portfolio, the diversification benefits of adding emerging markets could actually reduce your overall risk. More importantly, I think it will improve your returns in the years ahead: valuations are considerably lower than they are in developed markets, and combined with higher economic growth rates, emerging markets are very likely to outperform over the next decade.
This low valuation/high growth dynamic should also provide a decent cushion against any downside volatility, or worse, a crash in global share prices. Interestingly, there is even a proven strategy available today that converts this volatility into an advantage for investors. That strategy is described in the last section of this paper.
How large are emerging markets?
If we are to arrive at some reasonable judgment regarding the appropriate exposure of an investment portfolio to emerging markets, it is important to understand their size and importance to the world economy. The table below presents the total market capitalization of the various regions of the world. Note that the United States represents only 36.2 percent of the world’s market capitalization. Emerging markets represent 24.6 percent. Thus, if an investor wishes to hold a global portfolio weighted by market capitalization, almost one quarter of that portfolio would consist of emerging market equities.
Another metric that might be used to judge the appropriateness of an emerging markets equity allocation is to examine their share of world GDP. Inter-country comparisons can be tricky, requiring exchange rate and purchasing power parity adjustments. In one estimate made by the International Monetary Fund, emerging markets have already exceeded the GDP of the developed market countries as is shown in Figure 1 below.
According to the World Bank, by 2020 both China and India will have GDPs exceeding that of the United States.
The World Bank reduced its growth forecasts for the global economy in its January 2015 report summarized in Figure 3. But it noted increasingly divergent trends. The Bank remains pessimistic about the prospect for the developed world but more optimistic about the emerging economies. While growth has slowed in the developing world, the growth prospects for emerging-market economies remain substantially higher than those for the more mature economies. A major reason for the divergence is the substantial differences in demographies.
Populations are aging rapidly throughout the developed world. The ratio of the working-age to non-working age population will fall sharply over the next decades as is shown in Figure 4. By the end of this century, Japan will have more non-workers than workers. On the other hand, populations in India and Brazil will be getting younger. Even in China, with its one-child policy, the demography will remain far more favorable than it is in more developed economies, for at least the next decade. Countries with younger populations tend to grow faster.
The different metrics of size and home country bias
While there is no single measure of the size of emerging markets to guide an appropriate weighting in globally diversified portfolios, the discussion above suggests a range of possible parameters. Emerging markets represent about 24% of the world’s equity market capitalization. Float-adjusted, the number is closer to 17%. With respect to economic activity, a weight of about one-half would appear appropriate, where the economic outputs of various countries are adjusted for purchasing power parity. Emerging markets, with their younger populations, are forecast to grow more rapidly in the future – suggesting that the relative size of these markets will increase as well. Moreover, more firms are likely to be privatized as economic reforms are implemented in these countries. Thus, their share of global capitalization should grow as well.
Despite all this, investors in the United States hold a far smaller share of EM equities than would be consistent with this data. Individual investors hold less than 5 percent of their equity mutual funds in funds specializing in EM. Institutional investors tend to hold more, but the typical allocation is generally less than 10 percent. The “home country bias” appears to be very strong indeed.
Other portfolio considerations
When considering the inclusion of an asset class in an investment portfolio, two other factors need to be considered. Risk and return are essential considerations in building optimal portfolios.
As mentioned earlier, investing in emerging-market equities does involve additional risk. Their equity markets are extremely volatile and some nations have relatively unstable governments. There are also currency risks to consider (or the need to engage in potentially expensive currency hedging). Risk mitigation would indicate a smaller share of one’s investment portfolio should be devoted to emerging markets than the previous discussion might suggest.
Of course, portfolio considerations can cut the other way. As long as the correlations with EM equities are moderate, adding volatile EM equities to a globally diversified portfolio can actually decrease portfolio risk.
Return considerations would justify that a significant share of an investment portfolio should be devoted to emerging markets. The U.S. equity markets have rallied sharply since the depth of the financial crisis in 2008, and present valuation levels suggest that future return will be far more modest.
One of the best predictors of long-run equity returns is the so-called CAPE ratio – the current price of the broad U.S. stock-market index divided by the average earnings of the component companies over the past ten years.* This “cyclically adjusted P/E ratio,” or CAPE, is not a reliable predictor of returns one or two years in the future,