This content is from: Portfolio

Emerging-Markets Investing for Wimps

Multinationals based in developed countries offer an entry point for the cautious.

  • Dan Weil

Investing in emerging markets is turning fashionable again, as stocks there have rebounded sharply over the last 16 months. Star fund manager Jeffrey Gundlach, CEO of DoubleLine Capital, is one who has taken the plunge, announcing in May that he established positions that will pay off if emerging market stocks outperform U.S. stocks in coming years. But some money managers take issue with the general idea of investing directly in emerging markets.

These markets are notoriously volatile, they note. Investing in emerging markets also involves significant currency risk, and fees for emerging-markets investment funds are generally much higher than for developed-markets funds. In addition, in the last few years emerging-markets stock moves have become more correlated with those of U.S. stocks.

“I haven’t done much with emerging markets, because all those things are true,” says retired hedge fund manager Chris Litchfield, now a private investor in Greenwich, Connecticut. “My style is oriented toward getting good information about investments I like. That gives me more confidence.”

He’ll go to information services such as Value Line and Bloomberg to get the skinny on U.S. companies. “I just don’t have that with emerging markets,” Litchfield says. “It’s kind of an information issue.” With all the different currencies, rules, and regulations in emerging markets, it’s hard to evaluate companies there, he says. “I have a hard time pulling the trigger because I can’t get my conviction level up.”

Some money managers say investors can avoid much of the risk by investing in U.S. multinational companies, which generate a substantial chunk of their revenue in emerging markets. Indeed, developing countries account for about 11 percent of sales for S&P 500 companies.

“You may not get exposure to 100 percent of emerging markets, but you can get a significant part of it,” says Charles Lieberman, chief investment officer at investment management firm Advisors Capital Management in Ridgewood, New Jersey.

As for volatility, the iShares MSCI Emerging Markets exchange-traded fund returned 17.8 percent this year through May 23, more than doubling the return of the iShares Core S&P 500 ETF, which gained 7.8 percent. But in 2015, the emerging-markets ETF lost 16.2 percent, while the S&P 500 ETF eked out a 1.3 percent gain. Meanwhile, the emerging-markets fund has an expense ratio of 0.72 percent, compared with 0.04 percent for the S&P 500 fund, according to fund tracker Morningstar.

“There are times when the U.S. market is up somewhat, and emerging markets really run, and then you can make more in them,” says Michael (Mick) Heyman, a former portfolio manager for fund giant Invesco and now a principal of Heyman Investment Counseling, a San Diego–based registered investment adviser. But big losses tend to exceed any gains, he argues.

A number of factors make emerging markets volatile. Economies themselves are more volatile than in developed countries. Corruption is more common, the rule of law is often less reliable, and corporate accounting isn’t as accurate. Many emerging markets discriminate against foreign companies.

“There are risks in emerging markets that there aren’t here,” Litchfield says. “We’re unlikely to have a coup. We’re unlikely to have a company nationalized or privatized overnight when I’m asleep.”

Emerging-markets currencies also are often unstable. Many dropped sharply from mid-2014 to early 2016 and have rebounded since. Rising emergency-markets currencies boost foreign investors’ returns. But emerging-markets currency declines cause losses for foreign investors, unless they hedge their currency exposure.

“U.S. multinationals are kind of a chicken’s way to invest in emerging markets, but it works for me,” Litchfield says. “I’m just as happy to let Johnson & Johnson and 3M deal with the currency issues.”

Then there’s correlation. The average correlation between the S&P 500 index and the MSCI Emerging Markets Index rose to 0.755 in the period between 2010 and mid-May 2017 from 0.585 in the period between 1990 and 1999, according to Bloomberg data compiled by Reality Shares, a San Diego money management firm. A correlation of 1 indicates two markets are perfectly correlated, while zero indicates the markets are completely uncorrelated.

Part of the argument for investing in emerging markets has been that they add diversification to U.S. portfolios through their lack of correlation. “The world is so connected now that it’s a lot harder to find non-correlated assets,” says Eric Ervin, CEO of Reality Shares. “Computer-driven arbitrage trading has driven correlations higher.” With U.S. stock valuations standing above their historical averages, the need for diversification is particularly poignant.

And what do you get from your emerging-markets investments for all that correlation? “Volatility,” Ervin says. “Just diversifying equity positions across the world doesn’t get it done.”

He doesn’t object to all direct investments in emerging markets. For example, the rise of the middle class in developing economies will benefit a lot of local businesses. If you can identify those businesses, investing in them makes sense, Ervin says. “But you can’t do that with a traditional index that overweights large-cap companies.”

Investors not content to get their exposure to emerging markets through U.S. multinationals can consider diversifying to foreign multinationals, Heyman says. He notes that big European companies such as Unilever and Royal Dutch Shell are trading at lower valuations than their U.S. counterparts and with higher dividend yields. “You aren’t adding a lot of diversification, but you are getting some benefit,” he says.