Should Emerging Markets Play a Role in Your Portfolio? (2024)

Emerging-markets investors haven’t been feeling much love lately. As international stocks in general have fallen behind the U.S. market for more than a decade, emerging markets, which are generally defined as countries that have lower levels of income per capita and are making the transition to become more developed, have been even weaker.

Over the trailing 15-year period through June 30, 2023, the Morningstar Emerging Markets Index has generated annualized returns of just 3.1% per year, compared with 4.1% for the Morningstar DM xUS Index. The picture looks even worse over the past 12 months. As developed-markets stocks have rallied to a 17.1% gain, emerging-markets stocks have gained just 4%. As a result, diversified emerging-markets funds (including mutual funds and exchange-traded funds) have suffered about $8.9 billion in net outflows for the trailing 12-month period through May 2023.

These disappointing results notwithstanding, there are still valid arguments for investing in emerging-markets stocks. In this article, I’ll look at risk-adjusted returns over longer periods, as well as other reasons investors may not want to give up on emerging markets just yet.

The Rise and Fall of Emerging Markets

By definition, emerging markets should have greater growth potential than more established equity markets. As mentioned above, emerging markets generally produce less economic output relative to the size of their populations. As these countries become more industrialized and integrated with the global economy, rapid economic growth can follow, often accompanied by robust equity-market returns.

That is exactly what happened in the late 1980s and early 1990s. The MSCI Emerging Markets Index dates back to the end of 1987, just as global economies were opening up and investment capital was flowing into markets that were formerly unavailable. As a result, rolling three-year returns for the MSCI Emerging Markets Index trounced more-developed markets by healthy margins through over most periods up until early 1995.

The trend reversed in the mid-1990s following the Mexican peso crisis in December 1994 and the Asian currency crisis in 1997. Emerging markets fell behind their developed counterparts from 1994 through 1998, and lagged again in the tech correction in 2000. Driven by robust economic growth in China and rising global commodity prices, emerging markets then entered a secular bull market that lasted until the global financial crisis in 2008.

After staging a strong (albeit partial) recovery in 2009 and 2010, emerging markets ran hot and cold in the following years. Both 2013 and 2021 stand out as examples of what can go wrong. Emerging-markets stocks fell about 17 percentage points behind developed-market issues in 2013, when the U.S. Federal Reserve announced that it planned to slow down its bond-buying program and tighten monetary policy. They fell out of favor again in 2021 because of market worries over slower economic growth and regulatory uncertainty in China, which makes up about 30% of the MSCI Emerging Markets Index.

These dramatic swings in performance were accompanied by above-average risk levels. As shown in the table below, standard deviation for the emerging-markets benchmark has been about 30% higher than that of developed markets since 1988, and emerging markets have also been subject to more extreme drawdown risk. Recovery times have been prolonged, as well. After the painful drawdown during the global financial crisis, for example, emerging markets didn’t fully recover until nearly 10 years later.

However, emerging markets’ volatility has been partly offset by their relatively low correlations with U.S. markets. The correlation coefficient between emerging markets and the U.S. equity market has averaged about 0.66 since performance data started in 1988. As a result, adding emerging markets to a globally diversified portfolio (including both U.S. and non-U.S. stocks) has led to better risk-adjusted returns more often than not. To test this, I created two separate portfolios: One with a 30% stake in developed-market stocks and the remainder in U.S. equities, and the other with a 20% stake in developed-market stocks, 10% in emerging markets, and the remainder in U.S. equities. The emerging-markets version came out with better risk-adjusted returns in about 68% of all trailing three-year periods since 1988.

Assessing the Odds Going Forward

Will emerging markets continue to add value going forward? There are a few key considerations. The dollar’s strength versus other major currencies is one of the most important ones. Emerging markets typically fall behind when the dollar strengthens, which is one of the main reasons they’ve lagged over the past 15 years or so. A strong U.S. dollar often hurts emerging-markets economies because it raises the cost of imports (including food and energy) and leads to less foreign investment.

Valuation is another key consideration. Valuations for emerging-markets stocks have declined, leading some investors to argue that they’re currently undervalued. In terms of relative valuation, though, emerging markets haven’t declined all that much. Emerging-markets stocks typically trade at a discount to stocks from developed markets, partly reflecting their higher levels of political and economic risk. Emerging markets also have fewer safeguards for investor protection and can be subject to bribery and corruption. Over time, price multiples such as price/book, price/sales, and price/earnings are typically about 40% lower for emerging markets relative to the Morningstar US Market Index.

Viewed from this perspective, valuations for emerging markets don’t look all that compelling. The Morningstar Emerging Markets Index currently trades at about 11.4 times earnings for the trailing 12-month period, compared with a longer-term average of 13.5. Relative to the U.S. market, though, the P/E multiple is now 0.56, which is only slightly lower than the longer-term average of 0.59.

Another argument frequently made in favor of emerging markets is their greater growth potential. Based on data from the International Monetary Fund, emerging markets made up about 58.3% of global gross domestic product and 86.1% of the global population in 2022. As markets continue to develop and modernize, emerging markets’ share of the global economy should expand. However, there’s no guarantee that the rapid economic growth many investors now expect will materialize, or that if it does, economic growth will translate into stock market gains for emerging markets.

Conclusion

Emerging markets’ growth potential and generally low correlations with more developed markets make them worth including in a diversified portfolio. A prolonged period of weakness in the U.S. dollar could also provide a tailwind. However, their higher levels of risk make deviating from the global market-cap weighting (currently about 8%) a risky bet.