The short answer
The short answer is: it may be that this upcycle will feature emerging markets more prominently than in the past. But you should own only as much as will allow you to sleep soundly at night. In all likelihood, that will be less than an optimal weighting, but knowing and respecting your tolerance for risk is more important.
A somewhat picky aside (very skippable)
The term “emerging markets” has some ambiguity to it. For as long as I’ve been involved in stocks, investors have called Singapore an emerging market even though citizens there are on average as well-off as those in the US or Western Europe. In contrast, they’ve called Germany a developed market, even though Germans by and large don’t have great interest in equities and very little of the economy is publicly listed.
What the term “emerging markets” should mean is “stock markets in emerging economies,” typified by countries like the BRICs, Brazil, Russia, India and China.
Emerging markets are attractive…
The attractions of emerging markets–and their stocks–are:
1. their economies, or at least some large portion of them, are growing extremely rapidly, as they try to catch up with the developed world,
2. their growth is that much faster because they are typically following a development path blazed by others, and
3. foreigners who have already lived through similar, though perhaps slower and lengthier, development phases can appreciate the emerging economies’ growth potential far better than locals. Therefore, in most instances the stocks are cheap.
…but it’s risky
Investing in emerging markets is much riskier than investing in one’s home market, though:
1. the local political framework may not be stable–and it may not be particularly favorable to foreigners. This “unfavorable” aspect can range from the relatively benign restrictions every country has on foreign ownership of key industries (remember, Rupert Murdoch had to become a US citizen before he could build his American media empire) to the bumiputra program–and, more recently, capital controls that prevented foreign investors from exiting the country–in Malaysia.
2. for any developing economy that has hitched its growth star to US or European customers, both the economy itself and the publicly-listed stocks may be very sensitive to the ups and downs of GDP growth in the developed world. So they can be ultra-cyclical.
3. perhaps most important, for many emerging markets the big buyers and sellers are foreigners. When foreigners decide the cycle is turning and it’s time to divest emerging markets stocks and replace them with (defensive) G 7 bonds, there are few, if any, local pension plans or mutual fund groups to absorb the selling. So stocks go down a lot.
I think investors tend to forget #3 because the last two emerging markets crises–Mexico in the early Nineties and Asia ex Japan in the late Nineties–were caused by big-time macroeconomic mistakes by the countries involved. But the fact still remains that stock markets in countries where average citizens don’t earn enough to think about stocks as investments for themselves are at least partially hostage to the whims of foreigners.
The traditional take on investing in emerging markets
The typical thought pattern for a portfolio manager in, say, the US , who believes the worst of an economic downturn is past and he/she should become more aggressive is:
I’m loaded up with slow-growing, large-cap, dividend-paying, economically less sensitive stocks–the ones that look and act as close to government bonds as I can get. That was great during the downturn, but now I’ve got to add risk to benefit from the upturn. I’ll sell some of what I’ve got and replace it with economically sensitive domestic stocks, plus small-cap, then international and finally–at the far end of the risk spectrum–emerging markets. When it’s time to head back into the storm shelter, I’ll just reverse my steps.
Investors are taking a different approach in this cycle, I think
Individual investors, and professionals as well–to the degree that their mandates from clients allow–seem to me to be going through a somewhat different thought process in the current upcycle. I think it’s something like this:
When I look at the MSCI World Index or its FT equivalent, I see that 45%+ of the market cap is the US, and 10%+ each is the next two largest markets, the UK and Japan. So two-thirds of what I get from the developed markets index is either the epicenter of the financial industry meltdown (US + UK) or exposure to an economy and stock market that have been more or less asleep for 20 years. That’s an awful lot of dead weight to carry around.
As to the emerging markets, their economies are an awful lot bigger than they were ten years ago (see my posts on purchasing power parity GDP for details). If the US and UK do well, emerging markets should do very well. But if, on the (more likely, in my opinion) other hand, the US and UK just limp along, the emerging economies are now big enough to have a good shot at growing, from the strength of their trade with each other and from their own domestic demand. So, for the next couple of years at least (as far as we need to worry about today), there are more possibilities for emerging markets do well than there are for most of the developed world.
And, who knows–it may be that foreigners won’t have their usual panic attack and dump out their emerging markets exposure when the cycle turns down again.
The same argument, put a different way:
in creating a portfolio, your strongest convictions don’t have to be about the areas you want to overweight. Your strongest beliefs can easily be about what you want to avoid. In the latter case, you establish your overweights almost by default. So, if you think the world is entering a period of economic expansion and you don’t think you’ll participate fully in it if you hold US, UK or Japanese securities, then you underweight them and overweight everything else–namely, continental Europe and emerging markets.
Anyway, although investors around the world have been buying emerging markets stocks for some time now, the next development–and the next real surprise to the market–may be that they buy more rather than reduce their positions.