Emerging markets have underperformed US stocks so far in 2011 with WWO (green) emerging -4.4% while the S+P 500 is +5.4%.
[click chart to enlarge]
One would expect that the “hot money” of retail investors, which tends to buy high and sell low, would be quick to pull the trigger and chase higher performer assets. And they did. Emerging markets stock mutual funds shed 0.4% of assets in the week-ended Tuesday Feb 15., emerging markets stock ETFs redeemed 2.1% of assets, or $3.1 billion
But according to what the mutual fund companies tell us, their professional and experienced managers on the other hand would have the discipline to examine whether or not 8 weeks of data justify a major change in their investment strategy. They might be expected to take a closer look at whether the political instability of the headlines or the signs of inflation really warrant the wide divergence in performance of the last 8 weeks. Perhaps it might represent a chance to rebalance at attractive prices.
According to aNew York Times articleit seems that those investment “professionals” are as fickle as the most trigger happy individual investor. Seems to me the conventional wisdom of the asset managers suffers greatly from an investing pitfall long pointed out by behavioral economists. It’s called “recency”, attributing long term trends by placing too much weight on very recent data.
Inflation Friend or Foe of Emerging Markets ?
The article notes that signs of commodity inflation were already evident last year. But at that time the conventional wisdom was as follows
…the fortunes of many companies based in fast-developing regions like Asia and Latin America are linked to commodity production, which stands to benefit when inflation rises. That would explain why nearly three-quarters of professional money managers surveyed by Russell Investments late last year described themselves as “bullish” on emerging-market equities, even as inflation worries began to climb.
According to the article though, commodity inflation now is an unambiguous negative for emerging markets,
Seems to me those professionals who have so turned against emerging markets because of commodity based inflation should have been slower to flip their view. Of the 10 largest countries in the Vanguard Emerging ETF (VWO), one is energy self sufficient (Brazil), three are energy exporters (Russia, Mexico and Indonesia), and four are major exporters of other commodities (Brazil, South Africa, Russia and Mexico.)
Political Change in the Middle East Means More Political Risk in Asia and Latin America?
There is only one Arab country with any weighting in the emerging markets indices-- Egypt is .2% in VWO. The emerging markets are of course dominated by Latin American and Asian countries, most of whom went though a period of throwing off state run dictatorships decades ago. The notable exception is China.
Apparently among market “professionals” a new realization about “political risk“ is responsible for the emerging markets selloff: Does the fall of Mubarak, Gaddafi or the leaders of Bahrain or even Saudi Arabia really increase the political risk of an index weighted 57% Asia and 23% Latin America?
Apparently a chief investment officer managing hundreds of millions thinks so. That growing instability served as a “stark reminder of the political risks in the emerging markets,” said Jack A. Ablin, chief investment officer at Harris Private Bank in Chicago.
…Mr. Ablin noted that so far this year, investors have not been rewarded for exposure to greater political risks abroad.
The second quote is a classic case of recency, as if one can say anything about the risk and return characteristics of an asset class after two months. The major political risk in emerging markets is in China and if it took a revolution in Egypt to get an investor thinking about that, he hasn’t been evaluating risk and reward correctly for a long time.
And speaking of "recency" and lack of perspective... How about this quote from Bernard Bauhmohl, "Chief Global Economist at the Economic Outlook Group in the Feb 28 Wall Street Journal article entitled 'Stock Rally Slips, Falls as Oil Surges':
" I don't recall another time when there's been this much uncertainty about where the economy and financial markets are headed over the next year or two".
Hmm.... let me think really hard. Maybe, maybe there was this much uncertainty in the fall of 2008 when the Treasury Secretary and the Federal Reserve Chairman told the President and leaders of Congress the world financial markets were in danger of freezing up and the world is headed into a great depression. Boy, are memories short.
Investment professionals seem to be a fickle lot. I attribute it to a mix of lack of a long term strategy, a herd mentality, or simply fear of underperforming their peers. I was well aware of these factors affecting manager behavior but this number was amazing:
A survey by Bank of America Merrill Lynch found that only 5 percent of professional fund managers were “overweight” on emerging-market stocks in February, meaning they held a greater stake in such shares than their investment strategy would normally call for. In January, that figure stood as high as 43 percent.
A 38% swing in investment strategy based on a month of price activity! I think the smart money is behaving pretty stupidly.
So let’s take a step back. What has really changed in the long term picture? I don’t always agree with PIMCO’s Bill Gross (who manages several 1000x the amount of money I manage). But it is hard to disagree with this:
"Risk/growth-oriented assets (as well as currencies) should be directed towards Asian/developing countries less levered and less easily prone to bubbling and therefore the negative deleveraging aspects of bubble popping. When the price is right, go where the growth is, where the consumer sector is still in its infancy, where national debt levels are low, where reserves are high, and where trade surpluses promise to generate additional reserves for years to come. Look, in other words, for a savings-oriented economy which should gradually evolve into a consumer-focused economy. China, India, Brazil and more miniature-sized examples of each would be excellent examples. The old established G-7 and their lookalikes as they delever have lost their position as drivers of the global economy."
That description is no less relevant at the end of February 2011 than it was a month earlier, back when those surveyed were comfortable overweighting emerging markets. The political risk in the major emerging markets of Asia and Latin America shouldn’t be dismissed but it hasn’t changed because of the current upheaval in the Arab World.
Looking at the list of countries that make up emerging markets indices, there certainly is not an unambiguously negative impact of rising commodity prices. If there was, those markets wouldn’t have outperformed throughout last year’s commodity rally.
An Often Repeated Story in Emerging Markets
We have seen this before, emerging markets are volatile and that volatility is exacerbated by investor behavior. Those who get into this asset class in performance chasing bail out on the first sign of volatility on the downside. Clearly those investors include both individuals and institutional “professional investors."
- $100 invested in the emerging market index when it began in 1988 was worth $2006 at the end of January 2011. That same dollar invested in the S&P 500 was worth $876.
- The annualized return was 13.87% for emerging markets vs. 9.86% for the S&P 500 from the beginning of the emerging index in 1988 through end January.
- One need not expect such a large divergence in performance going forward to justify an overweighting in emerging markets.
- Certainly a strong outperformance by US markets for a 2 month (or 12 month, for that matter) period should change that view. But one has to be able to withstand this volatility. (Chart below is for Vanguard Emerging Market Index fund.)
For those that share the view towards overweighting, this recent underperformance for emerging markets is probably a good opportunity to gradually rebalance towards emerging markets, or to add holdings to reach a larger target allocation. But this only makes sense if you are committed to not being as fickle as the active manager that is managing billions in assets.
The immediate instruments of choice would be VWO the Vanguard emerging markets ETF, other broad emerging ETFS are SCHE, GMM and EEM. With my clients I also make use of funds from Dimensional Funds Advisors that are passive but give exposure to value (DFEVX) and small cap stocks (DEMSX) in emerging markets. Those are only available through advisors that have a relationship with DFA. There is a small cap emerging ETF (EWX) that might be worth investigating as well.
As I have stated below I recommend taking emerging market exposure in equities, not bonds. That rules out instruments such as EMB and EMLC.
Disclosure: I am long VWO.
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