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The added value of allocating to emerging markets (EM) has always been a topic of discussion among equity investors, especially when there was a large difference in performance with developed markets (DM). After a period of market decline, investors sometimes consider to lower the weight of emerging markets in their portfolio. What are the lessons that history can teach us?
In investing it is always important to take the long view. In a recent paper with data over the period from January 1988 to September 2015, we have taken a fresh look at the strategic allocation to emerging equities.
We started by investigating the long-term return characteristics of developed markets equities as measured by the MSCI World index and emerging markets equities as measured by the MSCI Emerging Markets index. The excess returns over cash of emerging markets have been roughly 75% higher than in developed markets. The volatility is 50% higher, which, when combined, results in a higher Sharpe ratio.
We also found that allocating to emerging markets increases the risk-adjusted performance of a traditional developed markets equity/bond portfolio. The portfolio volatility increases when you add emerging equity markets. But returns are even higher, from 3.7% excess return when you do not allocate to emerging markets to 4.6% excess return when you allocate 20%, resulting in a significantly higher Sharpe ratio (up from 0.38 to 0.43).
Given the potential for extra returns investors might be tempted to dynamically allocate to emerging and developed market equities. We tested the predictive power of many factors and find little to no predictive power. Only for price momentum did we find some evidence in predicting whether emerging markets will out- or underperform developed markets. If momentum works, you could argue that this implies that the weights of emerging and developed market equities in portfolio should not be rebalanced too often.
Investors can not only allocate to the emerging market equity premium, but also to other premiums within the equity market. We constructed a value and momentum index by each month considering the equally-weighted returns of the 33% most attractive stocks on respectively the earnings-to-price ratio and its 12-1 month momentum, assuming a 6-month holding period.
An emerging markets multi-factor quant portfolio consisting of a 50/50% allocation to the momentum and value factor premiums exhibits a significantly better risk-adjusted performance than the passive market portfolio. Specifically, the total return is over 6% higher than the market portfolio with similar volatility. The Sharpe ratio is 0.57 against 0.30 for the market index.
Emerging equity markets have disappointed in recent years. Yet, our empirical research shows that allocating part of an investor’s portfolio to emerging markets equity adds value and even more when the portfolio has exposures to the value and momentum factors. We therefore recommend investors to strategically allocate part of their portfolio to factor premiums in emerging equity markets.