One of the best-performing asset classes in the recent market rally has been emerging-market equities. Yet, some advisors avoid emerging markets, citing wild price swings, currency devaluations and protracted periods of poor performance. Other advi-sors, however, argue that holding EM equities significantly improves portfolio diversification.

To assess the portfolio role of EM equities, my firm, Tacita Capital Inc. of Toronto, analyzed the asset class’s long-term historical returns and risk, its correlations to major asset classes (in Canadian dollars) and surveyed the current product environment.

The reputation for volatility is well earned. The annualized standard deviation of the MSCI emerging markets index from January 1988 through March 2009 was 25.1%, the most volatile of all major asset classes and significantly in excess of the S&P/TSX composite index’s 16.3%.

Over the past five years, the volatility of EM equities has declined modestly with a standard deviation of 22.7%, to rank third after commodities and U.S. REITs. Stronger economic growth and, outside of Eastern Europe, banking systems that had avoided recent credit excesses are likely contributors to this improvement. Overall, however, emerging markets continue to be very volatile.

Investors were amply rewarded for this risk. The MSCI emerging markets index over the entire 21-year period had an annualized compound rate of return of 11.1%, far outdistancing the second-ranked S&P 500 composite index’s return of 7.9%. On the more important reward/variability metric, as measured by the Sharpe ratio, EM equities ranked No. 1 — with the best risk-adjusted performance of all the major asset classes. It also held this top risk-adjusted performance ranking over the past 10- and five-year periods.

Unfortunately, the strong risk-adjusted performance of EM equities has been accompanied by a material reduction in its diversification benefits.

From 1988 through 1997, the MSCI emerging markets index had correlations of 0.34, 0.39 and 0.41 with the S&P TSX composite, the S&P 500 and the MSCI EAFE indices, respectively.

Over the past 10 years, correlation has skyrocketed to 0.76, 0.66 and 0.79, respectively.

Superior long-term expected returns, which can be justified by the higher beta of EM equities, and not substantially enhanced diversification, is now the primary contribution of this asset class to a portfolio.

This is an important difference. A more correlated, high-return and high-volatility asset will play a reduced role in conservative portfolios compared with a less correlated asset of similar return and volatility parameters. Second, the performance drag of costs, always an important issue, becomes more critical when an asset’s role in a portfolio is primarily justified by higher expected returns.

Advisors can access EM equities through a rapidly expanding array of investment vehicles. A number of global and international funds have some exposure to this asset class.

This ranges from the mid-teens to nil as a percentage of their total holdings, so advisors need to factor this into their mixes. Canadian fund companies have also launched new EM funds over the past several years, including a low-cost exchange-traded fund focused on Brazil, Russia, India and China, as well as several value-style funds. F-class and corporate class choices have also improved.

There are now 25 EM-related ETFs available in the U.S., including regional, single country, style and market cap-based alternatives.

Many of these are small and thinly traded, so focus on the low-cost, larger funds such as iShares from Barclay’s Global Investors NA, as well as those from Vanguard Group Inc. Some Canada-based advisors are reluctant to use U.S.-traded ETFs because of concerns over the Canada/U.S. currency exchange rate.

However, we compared the performance of the iShares MSCI emerging markets index fund (in Canadian dollars) to the C$ MSCI emerging markets index: the tracking error is minimal. Currencies shouldn’t be a barrier to considering these ETF options. IE



Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office.