EM equities fail to consistently outperform developed markets – research

Emerging market equity returns do not outperform developed market returns in the long-term, according to research published today by investment advisors Capital Generation Partners.

The data counters the widely-held belief that investing in emerging markets for the long-term can generate stable outperformance.
The report, entitled The Truth about Investing in Emerging Markets, commissioned by the Judge Business School in Cambridge, shows that emerging market equity portfolios with three year and five year time horizons did not consistently outperform developed market equities, whether on a total return or a risk-adjusted basis.

The frequency of outperformance fell significantly for long-term portfolio investments. A ten year portfolio which entered the market in 1988 would have only outperformed an emerging market index 27% of the time, on a risk-adjusted basis. In comparison, a three year portfolio could expect to outperform developed markets 62% of the time for the same period.

The comparisons are based on the MSCI Emerging Total Return Gross Index versus the MSCI World Total Return Gross Index.  On an absolute basis, the percentage of times emerging markets outperformed developed markets were 74% for threee year portfolios, 65% for five year portfolios and 42% for 10 year portfolios. On a risk-adjusted basis, the figures were 62% for three year portfolios, 63% for five year portfolios and 27% for 10 year portfolios.

Ian Barnard, founding partner of Capital Generation Partners, said it is a common misconception that exposure to emerging market equities will deliver outperformance based on the assumption that GDP growth is an indicator of future stock market returns.
“This research demonstrates that not only is this assumption incorrect, but that outperformance has been limited to date, particularly among longer-term investors. There are several reasons for this misalignment of expectations versus reality, not least the complexities of emerging markets as a whole,” Barnard said.

The research highlights four key reasons for the mismatch in GDP and stock market growth. The first is that the expectation of high growth has already been priced in to emerging market stocks.

Japan is an example of this, he said. “During the 1980s expectations were overly optimistic for the next 20 years and, as a result, equity returns were negative during this time frame even though GDP has continued to grow.”

Other reasons include: the fact that businesses now operate internationally in both weak and strong economies, and that GDP growth is not driven by existing firms. Which means that by its nature venture capital is, therefore, more likely to capture the growth opportunity. Finally, in many cases, investors may not have access to the real growth story due to rules regarding international ownership and the re-direction of returns to other stakeholders.

The results do not mean that investors should discount emerging market equities, Barnard said. “Emerging markets do have a role to play in a balanced portfolio – on a carefully selected basis, and as a diversifier.” But exposure to emerging market equities in general does not offer reliable or guaranteed outperformance. Instead, investors should review what they expect to gain through their emerging market exposure.

“If it is a diversification to enhance their risk/return profile, then emerging markets as a whole has a role to play. If the main objective is to generate growth then a dynamic approach to asset allocation, based on careful and considered research, is absolutely critical,” he said.

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