Financial advisers in recent years have piled into emerging markets for the superior growth and the diversification benefits.
But the wisdom of that move is now in question as the European contagion spreads to developing markets, taking them down hard.
Through Sept. 29, emerging-markets funds had fallen 21.37% on average year-to-date, while the S&P 500 had lost roughly 6.34%, according to Morningstar Inc.
Compounding the losses on international investments, emerging-country currencies also have sold off, along with the euro.
Over the past decade, though, emerging markets, especially Asia, have come to be seen as a source of growth and diversification, said Morningstar analyst Kevin McDevitt.
RESILIENCE
Even through the 2000-01 recession, emerging nations experienced strong global growth and built thriving export-driven economies, he said.
“People have been buying into this idea that that's where growth is,” Mr. McDevitt said.
And lately, as questions grew about the safety of sovereign debt in developed nations, many emerging nations were seen as battle-tested, having come through the 1997 Asian currency crisis, the 1998 Russian debt crisis and the Argentina default in 2002.
But emerging-markets bears contend that the current sell-off once again shows that risky emerging markets provide little diversification benefit.
They note that all risky assets sold off in the 2008 crash. That year, emerging-markets funds, as a whole, fell 54.4%, according to Morningstar, while the MSCI Emerging Markets Index fell 64.5% from its high, Oct. 31, 2007, to a low, March 1, 2009.
“We're still in a world where everything is linked together — the world is not decoupled,” said Tony Hsu, founder and chief investment officer at Alethea Capital Management LLC, which manages $100 million in absolute-return strategies.
“Emerging markets are not going to hold up when you have the top two developed markets [the U.S. and Europe] not doing well,” he said.
The Chinese market, for example, was one of the first to weaken this year, Mr. Hsu said.
“The market is telling you China is not going to do well,” he said.
Indeed, some believe that the very idea of buying into fast-growing economies is flawed because gross domestic product growth isn't correlated to rising stock prices.
“If price-earnings ratios already reflect high expected growth, the returns might be low” from overpriced emerging-markets stocks, said Jay Ritter, professor of finance at the University of Florida.
In a 2005 paper, Mr. Ritter wrote that from 1900 to 2002, real stock returns and per-capita GDP growth were negatively correlated and that the benefits of economic growth accrued to startup firms rather than established companies.
The paper built on earlier findings by Elroy Dimson, Paul Marsh and Mike Staunton, academics at the London Business School, who also found no relationship between economic growth and equity returns.
The doubters of emerging markets have warned for years about these studies and the often lofty prices in developing markets.DIVERSIFICATION TOOL
But turning negative on emerging markets would be a huge change in thinking for advisers. Many now use emerging-markets funds as a core international holding.
Estimated fund flows show this. In the 12-month period through August, Morningstar's diversified emerging-markets stock funds gathered $26.9 billion in net inflows, equal to what was brought in by all other categories of foreign funds combined, Mr. McDevitt said.
“It's from performance chasing — people are seeing these great 10-year returns” from emerging markets, he said, noting that a decade ago, the reverse was true.
“No one liked emerging markets then,” Mr. McDevitt said.
The recent sell-off aside, emerging-markets bulls are sticking to their guns.
Volatility in developing markets “is to be expected in this type of environment,” said Doug Coté, chief market strategist at ING Investment Management LLC.
Weakness in one asset class isn't a problem within a broadly diversified portfolio, he said, contrasting the S&P 500's “lost decade” with the 19.4% annualized return from emerging markets over the 10-year period through August.
As for studies showing no correlation between economic growth and stock market performance, “that theory hasn't worked over the last decade” regarding emerging markets, Mr. Coté said.
“Short of a nuclear war, we're holding to an asset allocation model” with a healthy dose of emerging markets, said Paul Auslander, chief executive of American Financial Advisors Inc., which has about $200 million under management.
In his equity allocation, he has 50% in foreign stocks, and half of that is in emerging markets.
Markets such as this one force “hard conversations” with clients about how international holdings can diversify risk, “but the role of the planner is to do that,” Mr. Auslander said.
“It's easy to have that conversation when everything is going up,” he said."FIGHTING INFLATION'
Others, though still bullish, are a bit more cautious.
“We pulled back from emerging markets because they're fighting inflation,” said Randy Barkley, president of Tricord Advisors Inc., which has $65 million under management.
However, “long-term, we think that's where returns are going to be,” he said.
Tony Welch, co-founder of Sarasota Capital Strategies Inc., bailed on most emerging-markets investments in June and July.
“They'd just broken down technically,” said Mr. Welch, who runs about $70 million using tactical strategies.
He thinks that the European situation has sparked panicked selling of any risky asset.
“It's become a fear trade, which tends to create some values,” said Mr. Welch, who expects to get back into some emerging-markets funds once the extreme volatility abates.
djamieson@investmentnews.com
