The strategic case for emerging equities
10 minute read
A 10% value plunge in emerging market equities was reported on the MSCI EM index1 this year, making it the worst-performing asset class by some margin.
In contrast, developed equities are up almost 4%, as measured by the MSCI World stock market aggregate; other asset classes have been mostly flat or muted.
As our strategic asset allocation (SAA) for a moderate risk profile currently holds 9% in emerging market (EM) equities, this has obviously been a drag on performance.
Naturally, the question arises: is our holding justified?
To answer this, first of all it helps to understand whether our weight to EM equities is high, low, or about normal compared to some kind of neutral state, and then to understand the reasons why.
It’s hard to find good quality data on the allocation to emerging market equities amongst our peers.
However, we broadly observe that larger managers tend to invest a greater proportion of equity in emerging markets.
Indeed, they seem to typically offer more diversified portfolios in general than smaller boutiques, which often exhibit a bias to the UK home market – which comes with its own risks.
Nevertheless, in comparison to the wider MSCI All-Country World index, which comprises about 12.5% emerging market stocks, our moderate risk SAA holds approximately 20% of its equity in EM.
Whilst we may not have the highest allocation to EM equity2, ours is surely on the high side.
The rationale for this is not that we are particularly bullish on emerging markets – it’s more that we are slightly less optimistic on the long-term prospects for developed equities, based on their expensive valuations.
We therefore invest a smaller combined weight in global stocks than we otherwise would, but the amount in emerging markets is unchanged.
So, EM is higher as a proportion of total equity.
Another important factor to consider is how asset allocations change at higher risk profiles.
In theory, there is only one “optimal” portfolio, and investors should either put a fraction of their money in it (if it is too risky for them), or they should borrow to invest more money in it (if they can handle more risk).
But in real life, the use of leverage in this way is unusual, and as such we assume that investors generally do not employ it.
As a result, those with higher risk profiles have no choice but to allocate greater weight to potentially more rewarding asset classes.
Emerging market equities are both the riskiest amongst our set of nine, and boast the highest expected return – and consequently, our long-term portfolios have a greater proportion of equity in EM for those with a higher risk tolerance.
Focus on the long-term big picture
We have to keep in mind, though, that we are talking about strategic asset allocations designed to be held for the long-term.
It’s folly to judge them such over shorter horizons.
For example, the evidence suggests that equity valuations have very little correlation to the movement of markets over anything less than five years at minimum; before then, undulating sentiment holds sway.
Just as importantly, we have to look at the big picture, not the detail.
Whilst it is difficult to resist poring over the crimes of the worst offender, what ultimately matters is the performance of the overall portfolio.
This is why we diversify across a range of asset classes, for a battery of growth engines.
There is a last place in every lap, but the race isn’t over: the only question that matters is whether your portfolio is sensibly positioned today, for tomorrow.