The Trouble With Emerging Markets

Emerging markets were intended to bring greater rewards over the long haul because of soaring economic growth, and they have not lived up to expectations

John Rekenthaler 29 April, 2019 | 3:36PM
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Shanghai Stock Exchange, China

In the early 1990s, emerging market funds were all the rage. Their subsequent results have been weaker than even the sceptics believed.

The appeal was obvious. Higher risk, according to conventional theory, meant higher returns – and there was no doubt that emerging markets carried higher risk. They also offered excellent growth prospects. The Asian Miracle was a catchphrase. South Korea, to name one example, had increased its per-capita gross domestic product from $158 (expressed in current terms) in 1960 to $6,516 in 1990. From behind Zambia to ahead of Turkey!

And, surely, those income gains would lead to investment success. Investors bought domestic emerging growth funds – also named "emerging," also possessing higher risk – because eventually, their top-line expansion would lead to larger profits, which in turn would boost their share prices.

That asset management companies, in launching new funds, signalled that emerging market funds were not another flavour of sector fund, designed only for those with particular tastes. They were for every risk-seeking investor. They were an asset class. The materials accompanying emerging market funds explained how they not only could be expected to outgain their developed market rivals over time but would also offer diversification. The economic cycles for emerging countries would not necessarily match those of the developed world.

Emerging markets were intended to bring greater rewards, over the long haul, and they have not done that.

The problem has not been GDP growth, nor changes in per-capita income. At last report, South Korea's citizens earned just under $30,000 a year – higher than the Spanish. The giant emerging countries of China and India have progressed even more dramatically. By and large, the emerging markets have prospered, just as the fund marketers said they would.

Why Governance Matters

However, national growth does not neatly translate into corporate profitability. Emerging market countries are making more things, delivering more services, consuming more wares. Monies are being spent. But much of that cash does not make it to shareholders. It is squandered on profitless corporate expansions such as empire building; or placed into government officials' pockets; or siphoned off to a CEO's friends and family.

The lesson of emerging market stock funds: corporate governance matters, greatly. That topic received little attention when the funds were begun, but it ultimately proved to be the most important aspect of their future performance.

What's next? While emerging market stocks certainly could outperform over the next few years, they do not merit being treated as an asset class. Their diversification benefits appear to be dwindling, as the emerging countries become larger and ever-more entwined with the global economy, and their expected returns are suspect. It is not clear that buying a package of stocks from countries labelled as "emerging" makes more sense than, say, buying one from countries whose names begin with the letter B.

Best to let the professional managers make the decisions. They can incorporate companies from emerging markets as they see fit – greatly, modestly, or not at all, depending upon how their funds are defined and, for actively managed portfolios, their views on the trade-off between 1) higher-growth opportunities and 2) stronger corporate governance.



The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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John Rekenthaler

John Rekenthaler  John Rekenthaler is vice president of research for Morningstar.

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