The trauma of the Great Financial Crisis of 2008 emanated from the United States, intensified in the United States, and ultimately caused the most pain in the financial markets of the United States. It resulted in American equities being heavily discounted on quantitative measures to levels not seen in many years. The undeniable economic distress spurred the U.S. government and American business to take far more dramatic action than their global peers to alleviate the pressure.
When combined with a severely discounted starting price and the most aggressive pro-business policy responses, the returns for investors in American equities over the past decade have been nothing short of spectacular. The idea of buying the best-of-the-best has only magnified the returns, as investors who have flocked into American equities in droves following the recent tax cuts have driven valuations even higher.
However, while chasing the hottest performing market might be a strategy that sometimes encourages investor confidence in the moment, sound investing is not an exercise where following the herd is necessarily rewarded in the long run.
In the following article, we discuss why Emerging Markets can be an important component of a well-constructed portfolio in all environments, but also highlight why, on a tactical basis, the current setup offers an attractive entry point for the more dynamic investor.
Emerging Markets portfolio allocation for the long-term investor
In 1952, a young PhD. Economics graduate studying at the University of Chicago under notable heavyweights such as Milton Friedman (the original “Monetarist”) and Jacob Marshak (the father of Econometrics), put forward a new idea that would forever change portfolio management. Published by the Journal of Finance, Harry Markowitz’s “Portfolio Selection” paper introduced the concept that investors could create an “efficient frontier” of optimal portfolios, offering maximum expected return for a given level of risk. Modern Portfolio Theory (“MPT”) was created from the idea that examining the expected return and volatility for each security or asset class was not sufficient, but that by combining these metrics the optimal portfolio mix could be found which, with the benefit of diversification, would have a more attractive risk-reward profile.
Although MPT was born almost seventy years ago, it’s a lesson forgotten by many investors all too often as they “performance chase” the current hot stock, theme or asset class.
Given the U.S. stock market’s spectacular performance during the past decade, it would be natural to assume that there would be little reason why an investor should want to have owned any Emerging Markets exposure (or any other country’s stock market index for that matter). However, when constructing a portfolio for the long-run, it is important to understand the benefits of diversification offered by investing in a mix of different indices.
We will examine the long-run returns of owning only U.S. stocks (S&P 500 index) and then also combining them with a weighting of the Emerging Markets index (MSCI).
