financial advisors in search of enhanced returns for their clients should consider emerging-market equities as a component of their global allocations. The opportunity in this asset class is easily lost amidst headlines warning of China’s real estate bubble and India’s slowing economic growth.
The historical case for emerging markets (EMs) remains intact. From the MSCI EMs index’s inception in 1988 through March 31, this index had an annualized compound rate of return of 11.3%, outpacing the 7.2% return of the MSCI world index (WI) in Canadian dollars. This compensated investors well for the much higher volatility in EMs, as EM equities as a group had a higher Sharpe ratio than Canadian, U.S. or international stocks (as measured by the S&P/TSX composite, S&P 500 composite and MSCI EAFE indices, respectively.)
Recently, EM returns have badly lagged those of the developed world. Over the three years ended March 31, the 1.7% annualized return of EMs pales beside the 15.6% return of advanced economies, as measured by the MSCI WI. Slowing growth in EMs and the end of an era of extraordinarily cheap capital have clearly set investors’ nerves jangling.
The result of this performance lag is that EM equities have become increasingly inexpensive. As of March 31, the trailing 12-month price/earnings ratio of the MSCI EM index was 11.9, an almost 20% discount to its monthly average of 14.4 since 1995. And this index’s price/sales ratio of 1.0 is almost 10% below its long-term average.
Moreover, EM equities are strikingly inexpensive vs today’s developed markets. EMs’ current P/E ratio of 11.9 is 33% cheaper than the 17.8 P/E of the MSCI WI. Since 1995, the monthly price/sales ratio of EM equities has averaged 90% of that of the MSCI WI. As of March 31, this average had dropped to 75%.
Complementing this lower valuation, EMs exhibit much stronger growth prospects than the developed world. The U.S.-based Conference Board Inc. recently forecast that emerging and developing nations are expected to grow at an annual real rate of 4.3% per year from 2014 to 2019, more than twice the 1.9% projected for advanced economies. Longer term, demographics and lower public debt burdens clearly favour EMs’ growth prospects.
Another positive facet of EM performance is a gradual trend to lower volatility as EM economies have matured and more EM countries have joined the index. From January 1988 to December 2007, the annualized standard deviation of EMs was 24.9%. Since then, it has dropped to 19.5%.
Although the diversification impact of EM equities has weakened as the global economy has increasingly integrated, this sector still offers the potential to improve overall portfolio returns. Since 2000, a portfolio composed of 10% EMs and 90% MSCI WI had 0.6% improvement in annualized return vs a 100% MSCI WI portfolio, with only a miniscule increase in volatility. In particular, the higher volatility of EMs relative to the MSCI WI offers rebalancing opportunities.
Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own the securities mentioned herein.
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