Recent reports from consultants like Cambridge, MA-based EPFR indicate that the large allocation shift retail equity investors in developed countries have made in the past two years away from their home markets and toward emerging economies has begun to reverse itself. From early January onward, individuals have been taking money out of emerging markets funds and plowing it into developed markets equities.
What does this mean? What should we do, if anything, in response?
a look at the performance numbers
To put the current asset allocation shift into context, let’s take a look at three equity areas:
–the S&P 500, as representative of US large capitalization stocks,
–the MSCI EAFE (Europe, Australia and the Far East) index as a proxy for stocks in other developed markets, and
–the MSCI Emerging Markets index.
Just so I can get the numbers easily, I’m going to use the appropriate ETFs as proxies for the indices themselves. All returns are in US$. Here goes:
last 10 years
from March 2009 (the bear market bottom)
from Sept 2010
year to date
What does this show us?
–If we look at the last ten years, US stocks have had only half the return that developed markets outside the US have enjoyed and 1/6th the performance of emerging markets equities.
–The asset allocation away from the US in 2009-2010 didn’t affect the relative performance of the S&P vs. emerging markets that much. You have to remember that the earnings of publicly traded US companies have a healthy dose of emerging markets results in them. Still, I think the resilience of the US in the face of investor neglect is remarkable.
–The relative performance of the S&P vs. EM begins last September. In other words, it leads the asset allocation shift by four months. I think this means investors are reacting to the relative performance numbers, not causing them. That’s not so surprising. It suggests, though, that such allocation shifts are lagging indicators, not leading ones.
flows can have asymmetrical effects
Sorry about the less-than-clear title.
There’s a wide and deep pool of investors in many developed countries. Residents are wealthy enough to own stocks themselves. They also typically have pension plans that invest for them. And, of course, there are private equity funds and the big investment banks with their proprietary trading desks. Adjustments to changing prices by all these agencies tend to mitigate the effects of money flowing in and out of the developed equity markets.
In emerging markets, in contrast, many of these stabilizing factors–notably, the existence of pension plans or of individuals able to afford the risk of owning stocks–aren’t present. So flows of funds from developed countries in and out of emerging stock markets can have relatively large effects on prices.
Of course, your personal risk tolerances and your financial situation will be the primary drivers of your investment decisions. But I don’t think the asset allocation shift is important enough to make you rethink a sound asset allocation plan.
As for myself, I expect the flow of individual investor money back into developed markets means that smaller capitalization stocks there will do a bit better than they otherwise would, and that periodic market corrections will be shorter and shallower than we have seen during 2010.
Professional emerging markets investors, facing customer withdrawals, will likely emphasize larger stocks in more liquid markets. So “frontier” markets–which none of us have any business being in–will likely languish for a while.
The way I read the performance figures for the past year or two (over the past 12 months, EM and the S&P are about neck and neck), a lot of discounting of the need of emerging country governments to cool down overheating economies is already reflected in stock prices. The withdrawal of foreign “hot” money will speed the cooling down process along a bit, although the repatriation of funds may cause price weakness. I see this as a potential buying opportunity. Although I think it’s still too soon to act, the main message of the asset flow reversal is probably to set practical investors to thinking about when to increase emerging markets exposure.