While headlines typically center on the results for U.S. stock markets, we believe the diversification benefit from exposure in emerging-markets stocks is vital for the long-term success of our clients’ portfolios.
First, let’s define emerging markets and why we think it is important to have them in your portfolio.
Going back to 1988 when the benchmark MSCI EM (Morgan Stanley Capital International Emerging Market) index was created, the emerging markets asset class represented a group of 10 developing countries with the potential of strong economic growth. The tradeoffs for exposure to these countries were higher levels of political, legal, currency and operational risks.
Investors received the benefit of emerging-markets exposure in a significant way from 2002–2007 and periodically since then.
Major index returns (2001-2019)
Source: Dimensional Fund Advisor ReturnWeb
So, what’s changed over the last 20+ years? Emerging markets’ portion of world market capitalization has risen from 4% to 11%.
As you can see from the below chart, the increases have not been smooth or steady. Over the last 20+ years, emerging markets have been impacted, among other events, by the Russian and Asian financial crises and by the decline of Latin American countries’ economies.
Share of MSCI emerging markets in the MSCI AC World Index
The countries included in the benchmark, along with their weights, have also changed dramatically. Below is a chart comparing the countries within the emerging markets index in 2008 versus 2018.
Country weights within the EM index
Source: Callan Associates
Over the last 10 years, commodity exporters such as Brazil and Russia (which had been the leading components of the index) have experienced recessions. Meanwhile China, South Korea and Taiwan increased and now account for over 56% of the MSCI EM Index.
In addition, as noted by Callan, China is now the world’s second-largest economy and also the second-largest equity market compared to the U.S. ($12 trillion versus $26 trillion as of March 31, 2008).
Lastly, industry-sector weights have also changed over the last decade. Based on the following sector-weight comparison from Callan, note the significant increase in weight for information technology, along with steady growth for financials. Historically, large sectors like consumer staples, materials and energy have declined in weight.
Sector weights for the EM index
Source: Callan Associates
From a country perspective, dominance in Asia in the technology manufacturing space, along with behavioral changes on how consumers shop (social media and the impact of e-commerce) have a lot to do with the current weights of China, South Korea and Taiwan.
What does the future hold for emerging markets?
The most significant factor with emerging markets is not the underlying economic growth but rather the removal of restrictions, which creates opportunity for market access. China comes to mind, as it lifted the barrier for foreign investors to buy stocks in its mainland Shanghai Stock Exchange.
Just recently, MSCI began infusing China-A Shares in the benchmark, which are likely to increase over time. That said, our approach toward this asset class is based on broad diversification across developing countries, along with our bias towards value and smaller size.
In summary, as the official results are tallied for 2019, broad equity benchmarks had positive returns.
S&P 500 Composite 31.5%
Russell 2000 25.5%
MSCI EAFE 21.7%
MSCI Emerging Markets 18.4%
While the last 10 years since the financial crisis have been led by the U.S. market, it wasn’t that long ago (2009) that investors were frustrated over what is now known as “the lost decade,” in which U.S. large cap stocks declined while international stocks posted positive performance. We discussed this very topic in our recent video on international investing. As always, long-term investing requires discipline, patience and time.
If you have any questions about how to put together a well-positioned portfolio or would like to develop one, contact an advisor at Wipfli Financial.
