Emerging Markets and Conservative Portfolios— Two Peas in a Pod?

Emerging Markets and Conservative Portfolios— Two Peas in a Pod?


My wife and I enjoy watching the Travel Channel. With two young kids, there is only so much traveling we can do, and when we do travel we can only go so far, so instead of touring the world ourselves we live vicariously through the hosts on TV. One of our favorite shows is Bizarre Foods. If you are not familiar with it, the host, Andrew Zimmern, travels the world in search of the strangest foods he can find and then, of course, consumes them. This guy has eaten everything from insects to the least appetizing organs of any mammal, reptile, bird, or fish you can imagine. Given his ironclad stomach and unwavering resolve, it was funny to learn on a recent episode that there is one food Andrew won’t touch, and it’s not cobra heart or tuna eyeballs. It’s walnuts.

As with most of us, Andrew has that one food from childhood that we absolutely detested and still won’t touch to this day. The one that we couldn’t eat even if it cost us dessert privileges. The one that, despite our palate expanding exponentially since we were eight, still causes us to recoil in abject horror. For me, it’s peas. For my wife, mayonnaise. I’m certain you have one too. Once something is deemed your “Least Favorite Food,” it is hard to undo that opinion.

If I don’t eat another pea for the rest of my life (if only I could be so lucky), there is not much harm that will result. After all, I can always get my Vitamin K from other sources. But sometimes, we adopt steadfast opinions that prove detrimental. Take nuclear power for example. After the incident at Three Mile Island in 1979, the collective opinion developed that nuclear power was unsafe, and as result, we stopped constructing nuclear power plants for the next 28 years. As a consequence, coal-burning plants now generate about 50% of our domestic electricity, which seems like a mistake knowing what we know now about green house gases. Given the present disaster in the Gulf of Mexico, one has to wonder if offshore oil drilling will suffer a similar fate as nuclear power.

For equity investors, emerging markets have always been labeled as high risk investments, and it’s easy to understand why. Just in the past twenty years, there have been numerous crises in emerging market countries that led to dramatic declines for foreign investors as a result of declining stocks and devalued currencies. From October 1994 to March 1995, the MSCI Latin America Index lost 42% of its value due to the Mexican Peso Crisis. From August 1997 to August 1998, the MSCI All Country Asia Free ex-Japan Index fell 64% as a result of the Asian Financial Crisis. From September 1997 to September 1998, the MSCI Russia Index plummeted 92% after the country defaulted on its debt. I could go on with more examples, but you certainly get the idea.

However, investors’ perception of emerging markets as being high-risk has everything to do with the past and very little to do with the present or future for that matter. While over-indebtedness often played a key role in emerging market crises in the past, today we find ourselves in a unique position in regard to the finances of developed and emerging economies. According to Ramin Toloui, emerging markets portfolio manager at PIMCO, “Public debt in industrialized countries is over 90% of GDP, and it is projected to increase dramatically to almost 110% of GDP in the next five years, according to the International Monetary Fund (IMF). By contrast, in emerging markets, public debt is substantially lower at 38% of GDP and is projected to decrease to 34% over the same period of time.” So from the perspective of debt levels, emerging markets appear to be in much better shape than their “safer” developed country counterparts.

Along with financial crises triggered by excessive debt, two other commonly perceived risk factors in emerging markets are political and regulatory risk. To accurately gauge these types of risk, The Heritage Foundation, a public policy research institute, produces an annual Index of Economic Freedom that ranks 183 countries based on ten factors: business freedom, trade freedom, monetary freedom, government size, fiscal freedom, property rights, investment freedom, financial freedom, freedom from corruption, and labor freedom. What is least surprising is that countries like North Korea, Cuba, and Venezuela stand at the bottom of the rankings. What is most surprising is the composition of the top quintile, of which 39% of the countries ranked are considered to be emerging markets by either the IMF or MSCI. These select emerging market countries even manage to rank higher than “safer” developed countries like Norway, Israel, France, and Italy.

According to a report from Vanguard, How America Saves 2009, just 18% of the retirement plans that they administer offer emerging market funds and only 11% of participants who are offered these funds actually use them. While this initially may seem like the result of the home bias—the established tendency of investors to overallocate to their home country—the report shows that 98% of the same retirement plans offer developed market funds while 31% of participants use them. So there certainly seems to be a greater comfort level with the “safer” developed markets among those who set the menu of fund choices (the plan trustees) and those who choose the individual funds (the participants).

If investors continue to keep emerging markets out of their portfolios because they are too high risk, it will likely come at the cost of future returns. Emerging markets have historically produced higher economic growth rates and market returns than their developed market counterparts. And under present conditions, you can add to that fact the high debt levels among the “safer” developed countries that are likely to produce a headwind against their economic growth rates going forward.

What resonates most with me about Andrew Zimmern and his show, Bizarre Foods, is how he approaches every new food, no matter how strange, as if he were a blank slate. Through his attitude and his closing line, “If it looks good, eat it!” he continually reminds us that preconceived notions often prevent us from trying, and possibly enjoying, new things. But, our thinking isn’t always preconceived. Sometimes, it is based on previous experience or events, but because the world changes and evolves, that evidence continually needs to be reevaluated to verify the validity of our opinions and beliefs. Successful investing requires it.

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