Should You Add Emerging Markets To Your Portfolio?

Is it worth adding stocks or indices from emerging markets to your portfolio?

After all, the GDP growth of emerging markets had been phenomenal. In contrast, the GDP growth of developed markets had slowed down considerably.

Hence, for me, it used to be a no-brainer – yes, you should add emerging markets to your portfolio.

However, after reading IWDA vs VWRA – Are There Significant Performance Differences Between the Two Low-Cost ETFs? by investment moats, I started having second thoughts.

Maybe emerging markets are not as good as claimed.

Background on IWDA vs VWRA

For those of us outside of the US, we have a few popular world index ETFs to choose from:

• iShares Core MSCI World UCITS ETF (IWDA)
• SPDR MSCI World UCITS ETF (SWRD)
• Vanguard FTSE All-World UCITS ETF (VWRA)

Both IWDA and SWRD are near identical because they are tracking the MSCI World Index while VWRA is tracking the FTSE All-World Index.

ETF	Index Tracked	Holdings	Markets
iShares Core MSCI World UCITS ETF (IWDA)	MSCI All World	1650	Developed Markets
SPDR MSCI World UCITS ETF (SWRD)	MSCI All World	1643	Developed Markets
Vanguard FTSE All-World UCITS ETF (VWRA)	FTSE All-World	3267	Developed & Emerging Markets

The main difference between IWDA and VWRA is the inclusion of emerging market stocks – VWRA provides exposure to China and other emerging markets.

MSCI ACWI vs MSCI World

In his article, investment moats compared MSCI ACWI against MSCI World to represent the difference in performance between VWRA and IWDA.

We assume that MSCI ACWI index is equivalent to the FTSE All World index in this analysis.

Source: FTSE All World Index factsheet

MSCI ACWI vs MSCI World:

He concluded that there are periods where VWRA may outperform IWDA and periods where it may underperform. The difference is pretty small. 

On average, MSCI World did better than MSCI ACWI over different rolling returns. MSCI World also did better than ACWI recently, if you look at 2018 – 2020.

Source: Investment Moats

If you compare IWDA, SWRD and VWRA, you will notice that the lines follow each other tightly, but VWRA trailed IWDA and SWRD by a bit.

VWRA (orange) has been trailing IWDA (green)

Was it because emerging markets did not perform well recently? Or was it because developed markets also performed well recently?

#1 GDP Growth Does Not Translate Into Stock Returns

In theory, GDP growth should translate into stock returns.

1. Business profits tended to grow with GDP – the more the economy improves, the more earnings.
2. Earnings growth translates to more earnings per share.
3. Increase in earnings per share translates to a rise in stock prices.

However, there is empirical evidence from research by MSCI that suggests otherwise.

Aggregate Earnings And GDP

Intuitively, it makes sense. As the economy grows, businesses will reap more profits, and aggregate earnings will increase.

The research confirmed that aggregate earnings tended to grow at the same pace with GDP growth. 

Earnings Per Share

However, growth in aggregate earnings does not necessarily translate to an increase in earnings per share.

GDP growth can be due to two factors:

1. Growth of existing businesses in the country
2. Addition of new companies in the country

Based on the data from the research, most of the GDP growth, on average, came from the growth of new companies.

So, GDP growth resulted in more IPOs and more shares issuance in the public market. 

While aggregate earnings grew, the number of shares also rose, resulting in a dilution effect on earnings per share. 

Investors will have to sell their existing shares and buy into the new stocks to partake in GDP growth of the entire economy.

Private Companies

Private companies also contributed to GDP growth. For 2018, private companies account for 60% of GDP growth in China.

A lot of the growth from private companies were not captured in the stock market because it only consists of public companies.

Hence, there may be a disconnect between GDP and stock market returns.

Stock Prices

Stock prices may not grow at the same pace as earnings per share. It is because of the forward-looking nature of the stock market.

In high growth countries, investors tend to pay a premium for stock prices because they anticipated high earnings growth. It is the same reason why growth stocks are more expensive than value stocks.

Hence, if the earnings growth performs in line with investors forecasts, the price will remain the same. 

If growth expectations are high, it becomes increasingly harder for companies to perform in line with expectations. When high growth becomes unsustainable, the stock prices drop pretty fast.

When valuations are high, expected returns will be lower.

China’s growth rate for 2019 was 6.1%, the slowest pace for the past 29 years. The GDP growth rate for the US was 2.3% in 2019.

However, despite China’s impressive growth, the stock market returns have been the lowest among the US, the UK and Japan. 

The lower returns could be due to the US-China trade war too. The point is, markets are complex. 

#2 Higher Volatility

The standard deviation, a measure of volatility, of emerging markets over the last 30 years was 22% while the standard deviation of the S&P for the same period was 14%.

Political, social unrest, natural disasters could lead to inconsistent economy growth. All these factors contribute to higher volatility in emerging market stocks.

Investors sometimes find it hard to trust the regulations, accounting standards and reporting from companies in emerging markets. How confident are you with the numbers reported? It is also another risk that investors take on.

Also, these countries tend to have weaker, illiquid and more volatile currencies.

For the more risk-averse investors, emerging markets might not be worth the risk.

#3 Diversification?

The common reason for including emerging market stocks is diversification. 

Emerging market stocks tend to be less correlated to developed market stocks, or at least it used to be. 

In our current globalized world, the dependency of countries in emerging markets on other developed markets is increasing.   

Correlation is highest when you needed it to be uncorrelated the most. 

When a market crash, the correlation between developed and emerging markets increases – it defeats the point of having them in the first place.

In the recent COVID-19 crisis, emerging markets are worse off compared to their developed market counterparts.

Why then invest in emerging markets?

The US market makes up 60% of the MSCI ACWI index.

Will the US continue to remain as the world’s economic superpower? 

The Japan stock market never recovered from its height in 1989. It may happen to the US market too.

We will never know which country will emerge as the next superpower.

Hence, we should continue to hold a globally diversified portfolio (including both developed and emerging markets) to not miss out in investing in the next emerging economic powerhouse.  

Alternative to Investing in Emerging Markets directly

If you cannot bear the risk of emerging markets, there is still an alternative to gain exposure to emerging markets growth.

Many of the multinational companies in developed countries have businesses in emerging markets. Majority of their revenue and profits may come from emerging markets.

The S&P, for example, has many huge corporations that have businesses with significant markets share in emerging markets. Hence, investing in S&P gives you exposure to emerging markets indirectly without extra volatility that comes with directly holding emerging market shares. 

It also partly explains why developed markets also did relatively well recently – their earnings growth came from international sources.

Conclusion

Emerging markets may not be as good as others claim it to be.

Higher GDP growth does not necessarily translate to higher stock returns. 

• Most of the GDP growth was from new enterprises and private companies. 
• Higher GDP growth markets are like growth stocks in a sense they tend to be more overvalued because of the high earnings expectations from investors. They are willing to pay more to buy emerging market shares. High valuations resulted in a lower return for investors.

Emerging markets also come with higher volatility due to political and social instability.

Emerging markets are more correlated with developed markets in our modern globalized world. It reduces the diversification benefit of holding emerging market stocks.

However, there is still a possibility of a country emerging as the next economic superpower. To not lose out on that chance, we should always include developing markets in our portfolio.

It is the main reason why we diversify in a total market index – we cannot predict which stocks might be winners and which might be losers.

So, back to our main question: which ETF should you choose – IWDA which only includes developed markets or VWRA which includes both developed and emerging markets?

For me, I am holding VWRA because I do not want to lose out in case China (or any other country) emerges and takes over the world.

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