Certainly, history tells us that one common reason why people hold them is plain wrong. This is that emerging markets offer the prospect of stronger economic growth than we are likely to get in developed economies, and this should benefit shares.
However, while the premise of this argument is reasonable, the inference is not. Over long periods, there's no correlation across countries between GDP growth and equity returns. One reason for this is that investors anticipate growth, and so it should be embedded in share prices already. Insofar as this is the case, it is only unexpected growth that raises share prices.
But even this need not do so. Growth can benefit unquoted companies, foreign ones, or even - it has been known - workers. Insofar as it does so, listed companies don't benefit much.
If emerging markets are not a play upon economic growth, might they instead be a play upon general world stock markets, rising strongly when developed markets rise?
Not really. Looking at monthly price changes in sterling terms since January 1988 (when MSCI's data begins), emerging markets' beta with respect to the All-Share index is only just over one - 1.05 to be unwarrantedly precise. This suggests they rise one-for-one with the All-Share.
Like many numbers, however, this conceals as much as it reveals. This average beta splits, roughly, into three periods. From 1987 to the mid-90s, emerging markets had a low beta, suggesting that their returns had a large idiosyncratic element. From the mid-90s to mid-00s, their beta was high, consistent with them being a leveraged play upon developed markets. Since then, however, their beta has fallen, consistent with them becoming more mature; no asset can have a beta of more than one forever.
What's more, this average beta conceals a difference across market conditions. If we look at the 20 worst months for the All-Share since 1988, emerging markets underperformed in these, falling by 11.2 per cent on average against the All-Share's 8.8 per cent.
This suggests emerging markets expose us to tail risk - the danger of doing especially badly in bad times. For example, in September and October 2008, they lost 32.6 per cent in sterling terms compared with the All-Share's 22.4 per cent.
Herein lies the justification for emerging markets doing well in the long run. They must do so in order to compensate us for the risk that they will do really badly in bad times.
On average, they have delivered this compensation. Since January 1988 the 'alpha' on emerging markets - the monthly return not associated with All-Share returns - has been 0.56. This implies that if the All-Share were flat over a 12-month period, emerging markets would have risen 6.9 per cent on average.
However, just like its beta, this average alpha conceals three distinct periods. From the late 80s to mid-90s, alpha was generally high, consistent with emerging markets being a good-performing idiosyncratic asset - exactly the sort of thing investors want. In the late 90s, though, alpha turned horribly negative due to the Asian crises. Since then, it has generally been moderately positive.
Until, that is, very recently. In the last three years, it has actually been slightly negative.
There might be a reason for this. Since 2000, there's been a very strong correlation between emerging markets' alpha and movements in the US yield curve. Alpha has been high when the fed funds rate has fallen, and when 10-year Treasury yields have risen. Emerging markets do well when US monetary conditions are loosening and/or when growth expectations are improving - because expectations of stronger growth, which normally raise Treasury yields, also make investors more willing to take on risk.
Because the degree of US monetary stimulus hasn't much increased in the last three years, and because growth expectations haven't improved, so emerging markets haven't had the boost they often get from US monetary conditions. Hence their negative alpha.
Now, this does not mean you should rush out to sell your emerging markets funds. The Federal Reserve is unlikely to tighten policy soon, so monetary conditions won't turn bad for emerging markets for a while. And it's possible that growth expectations could improve, which would give them a further boost.
What it does mean, though, is that emerging markets are not what you might think they are. They are not a bet on economic growth in those countries. What they are is a bet on disaster risk not materialising; on US monetary policy being loose; and on global growth expectations (US Treasury yields) rising. These might be reasonable bets. But I suspect that they are not the reasons why many investors bought emerging markets funds.
