I first met Minh in 2003. He was doing chin-ups in the park beside Hoan Kiem Lake. In broken English, he asked me to join him for a beer. He then invited me to his home. The 28 year old engineer lived alone in Hanoi, Vietnam. It was, by far, the worst city dive I had ever been inside. The walls crumbled. He shared an outside toilet with his neighbour. His house leaked when it rained. “I going to build new upper floor,” he said. “My wife want that.”
Minh wasn’t married. He didn’t even have a girlfriend. But he did have drive and a dream. Twelve years later I went back to visit Minh, to meet his wife and newborn son. Minh’s family had their own bathroom, a new top floor and a roof that didn’t leak. Even the walls looked great. Minh proved what can happen when hard work blends with rapid economic growth.
I’m an emerging market junkie. I spent most of last year traveling around some of the fastest growing nations. I visited China, Malaysia, Indonesia, Thailand, Vietnam and Mexico. Over the past dozen years, economic change has been rampant.
So it might seem odd that I’ve never cared much for emerging market stocks—until now.
I knew that emerging market GDP growth runs circles around those of developed markets. I also knew, all too well, that such economies often run on bribes and corruption. Taxi drivers smile--then charge twice the standard fare. Pick pocket PhDs lift proceeds from the masses. Crooks rig ATMs for quick, efficient fraud. Shady legal frameworks and poor corporate governance also cause emerging market stocks to drag. According to a 2014 Blackrock study, they capture only 73 percent of their countries’ GDP growth. For example, if GDP grew by 8 percent per year, stock market growth would be roughly 5.8 percent.
Yale University’s Endowment Fund Manager, David Swensen compared emerging and developed stock market performances in his book, Pioneering Portfolio Management. Using numbers from the World Bank’s International Finance Corporation, Swensen said $100,000 invested in a broad, random selection of emerging market stocks in 1985 would have grown to 1.08 million by 2006. If it were invested in U.S. stocks, it would have grown to more than $1.3 million.
Much, however, depends on the methodology and time period measured. According to Dimensional Fund Advisors, the S&P 500 index averaged a compounding annual return of 10.4 percent between 1989 and 2014. Emerging markets did better, averaging 11.3 percent.
But instead of worrying whether one type of market will outperform another, it’s best to own both. Diversification reduces volatility. Sometimes, it even boosts returns.
Gregg S. Fisher, writing for the CFA Institute, reported that in the 20 years ending 2014, U.S. stocks averaged a compounding return of 8 percent per year. Emerging market stocks earned about the same. But he adds, “If you put 50 percent in the US market and 50 percent in emerging markets and rebalance every couple of months, you would earn closer to 9 percent.” By rebalancing, investors would pay less than the average unit price for shares. They would be selling a bit of what’s hot and buying a bit of what’s not. By doing so, their portfolio could outperform both funds.
Institutional money manager Ben Carlson gives another example of how combining different asset classes can improve returns. He looked at portfolio performances for U.S. large cap, U.S. medium cap, U.S. small cap, REITs and international stocks. Between 1979 and June 30, 2013, these asset classes averaged a compounding return of 11.32 percent per year. But if they were annually rebalanced, the portfolio’s compounding return would have been 11.73 percent. Volatility would have also be reduced.
Rebalanced Returns Can Beat Isolated Averages
|Time Period||U.S. Large Cap||U.S. Mid Cap||U.S. Small Cap||REITs||Int’lStocks||Average Return||Rebalanced Average Return|
Federal Reserve Data
Emerging market stocks have had a tough time lately. During the 3 years ending September 10th, Vanguard’s Emerging Markets Index (VEIEX) has dropped almost 10 percent, compared to a 45 percent gain for the S&P 500. Anyone rebalancing a diversified portfolio should now be adding money to emerging market shares.
Investors need patience. Diversification and rebalancing work. But the benefits take time—and perhaps an iron gut.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and The Global Expatriate's Guide to Investing: From Millionaire Teacher to Millionaire Expat.