Fund Investing

Though emerging markets might have underperformed U.S. equities in the long term, we find that the same is not true in Canada
By Ruth Saldanha | 01/05/19

As we discuss emerging markets and whether they make sense for Canadian investors, it is important to discuss dissenting voices. Morningstar’s John Rekenthaler argues that while emerging markets stocks could outperform over the next few years, their diversification benefits appear to be dwindling as the emerging countries become larger and ever-more entwined with the global economy. He also notes that emerging markets did not outperform U.S. equities.

About the Author
Ruth Saldanha is Senior Editor at Morningstar.ca

But they did outperform Canadian equities.

When we look at the MSCI Emerging Market Growth Index in Canadian dollars, we see that the S&P/TSX Composite Index has significantly outperformed year-to-date, thanks to run up in Canadian equities so far in 2019. However, over a longer time-frame, the Emerging Market has outperformed the Canadian Index. Even in 2018, The S&P/TSX Composite Index lost close to 9%, while the Emerging Market Index lost a little over 6.5%.

Index YTD Return 10-Yr Return15-Yr Return 2018 Return 
MSCI EM GR CAD10.62 9.26 8.48 -6.52 
S&P/TSX Composite TR17.11 8.84 7.41 -8.89 

Source: Morningstar Direct Data as of 04/29/2019

“It’s no secret that emerging markets have been more volatile historically than their developed counterparts. The argument for investing there must therefore be supported by the requirement for higher expected returns or diversification benefits from lower return correlations, or both,” say Perry Teperson and Tricia Wu of Leith Wheeler.

To see if this was indeed the case, Leith Wheeler undertook a 20-year study of emerging and developed markets indices. The study found that from December 1998 to October 2018, the S&P/TSX Composite Index had a return of 6.6%, while the MSCI EM Index clocked returns of 7.9%. However, it is important to note that the historical volatility for the MSCI EM Index was higher at 17.6%, as against volatility of 13.6% for the S&P/TSX Composite Index. The Sharpe ratios which calculates risk-adjusted returns were both 0.32.

Is the return worth the risk?

The authors also calculated what return premium was required from emerging markets to justify its higher risk, and found that if emerging markets can outperform other equity markets in the future by 1% or more per year, an allocation to emerging markets of more than 10% of an equity portfolio would be warranted, even if the higher risk repeats.

They argue that there are several reasons to add emerging markets to your portfolio. Emerging markets are a growing and significant part of global markets, and now represent more than 10% of global equity indices, a weight that has doubled in the last 15 years yet still under-represents the region’s share of global economic activity. A growing share of the world’s population lives in these countries, with China and India alone making up more than a third. EM countries also have a younger workforce with a growing middle class and a consumer base that is getting wealthier.

Good in theory, but not proper in practice

Rekenthaler acknowledges these fundamentals but points out that though monies are being spent, much of that cash does not make it to shareholders. It is squandered on profitless corporate expansions (empire building); or placed into government officials' pockets; or siphoned off to a CEO's friends and family. “Corporate governance matters, greatly,” he says.

This was a view echoed at the February Morningstar Executive Forum in Toronto, titled “ESG as a source of Alpha”, where all three panelists agreed that governance was the most important of the three pillars of ESG (environmental, social and governance) in emerging markets, and companies with good stewardship and governance in emerging markets are the most likely to outperform.

Be particular, avoid problems

Teperson and Wu say that “Well-managed companies in emerging markets can take advantage of the positive trends, providing our portfolios with opportunities for diverse earnings streams.”

Three companies they like are Chow Tai Fook, a Chinese jewelry company commanding the country’s largest retail network, bringing scale and brand advantage over its competitors but trades at only 13 times forward earnings and carries a dividend yield greater than 8%, Brazilian firm BRF S.A., the largest chicken exporter in the world to regions with growing meat consumption like the Middle East and Asia, which could potentially have a 50% upside to current valuation, and Truworths, a South African fashion brand with over 720 stores across their domestic market, trading at an attractive valuation of 11 times earnings.

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