Many of you like emerging market equities. But are they worth the risks?
Certainly they have outperformed over the longer term. Since MSCI’s data began in 2000, total returns on them in sterling terms have been 9.5 per cent a year. That’s 2.3 percentage points more than MSCI’s world index and 5.1 percentage points more than on UK stocks.
But these higher returns have been associated with higher risk. This risk is not merely that emerging markets are more volatile than developed ones. They are. But economic theory tells us that we should only be rewarded for taking on systemic risks – those we cannot diversify. Volatility on its own does not measure these non-diversifiable risks.
Instead, our problem is that emerging markets expose us to non-diversifiable risks. One is that they have a slightly high beta, of 1.1 with respect to either the UK or world markets. In itself, this isn’t huge. But emerging markets also suffer bigger losses in bad times than developed markets. Since 2000 their worst annual loss in sterling terms have been over 40 per cent. That’s ten percentage points more than the worst loss on UK or world markets. And this loss came in the 12 months to October 2008 when global markets were collapsing, which suggests their huge drawdowns are a systemic risk rather than an idiosyncratic one. We need higher returns to compensate us for this danger.
Also, emerging markets are more cyclical than developed market equities. Since 2000 each one percentage point change in US industrial production has been associated with a 1.2 per cent change in MSCI’s world index but a 1.6 percentage point change in emerging markets (in sterling terms). Not only did emerging markets under-perform in the great recession of 2008-09 but they also underperformed in 2015 and 2019-20 when US output also fell. This greater cyclicality means that emerging markets should do better than developed ones to compensate us for their greater danger of doing really badly in recessions.
Emerging markets’ outperformance, then, is not a free lunch. It’s a reward for taking on extra risk.
But is it a fair reward?
That depends who you are. If you are a very loss-averse investor – the sort who can cope with ordinary ups and downs of the market but are troubled by big losses – emerging markets’ big drawdowns are nasty for you. So perhaps their risk premium isn’t high enough. If on the other hand you have the psychological or financial means to cope with such large occasional losses, you can take on their risk.
Similarly, if you are retired with an inflation-linked pension and own only the property you live in you are less exposed to global cyclical risk than others and so can afford to take on such risk. For you, risk premium associated with cyclicality is something for nothing. If on the other hand you are exposed to cyclical risk – say because your job is in a cyclical industry or because you have a large property portfolio – then emerging markets add to your risk. Unless you are unusually risk-tolerant, this is a reason to avoid them.
Sadly, though, there’s another issue. We cannot be sure that the historic risk premium on emerging markets is a far guide to what really matters, which is the future risk premium.
Simple statistics tell us this. The risk premium on emerging markets relative to MSCI’s world index is volatile. Sometimes emerging markets investors have been lucky and seen good outperformance, and sometimes they’ve been unlucky. Even over a period of 21 years, however, the luck does not even out when returns are so volatile. History gives us only a sample of returns, and the sample might be biased.
The standard deviation of returns on emerging markets relative to the world since 2000 has been 15.6 percentage points. Which implies that the standard error around our observed 2.3 percentage points risk premium is 3.4 percentage points. One interpretation of this is that there’s a two-thirds chance of the true risk premium being between 5.7 percentage points and minus 1.1 percentage points. Maybe emerging markets are a bad asset that have enjoyed more good luck than bad this century, or maybe they’re a great asset that have suffered disproportionate bad luck. The numbers alone can’t tell us. And the fact that emerging markets have actually underperformed since 2010 only adds to the lack of clarity.
But, you might think, common sense is clear. Emerging markets are a little riskier than other equities and so should carry a moderate risk premium.
Common sense, however, can be misleading. It tells us that high-beta shares in the UK and US should outperform, but they don’t. It tells us that speculative Aim shares should outperform, but they don’t. And it tells us that cyclical value stocks should out-perform in the UK, but many haven’t.
All of which poses the question. If such risks haven’t paid off over the long term in the UK or US markets, why should they pay off in global markets? Risk premia are not guaranteed, even over long periods.
Yes, emerging markets should do better than other stocks in the long run, but we cannot be as confident about this as you might imagine.
