By definition, a due diligence consultant considers the investment merits of various asset classes and diversification strategies. For Prima Capital it is a continual process, especially because advisors today have increasing access to solid portfolio diversifiers like floating-rate loans, alternatives, and international fixed income—investments that go well beyond the conventional stock, bond, and cash categories. All of these not-so-traditional asset classes rise and fall on their own investment merits and all can enhance the overall potential of a portfolio. Emerging markets equity is currently a popular destination for assets, and not without reason.
No Time for Home-Country Bias
It's a well-documented reality that certain investors exhibit a natural tendency toward investments in domestic markets. They tend to hold optimistic expectations about the domestic market and are either pessimistic or indifferent about foreign markets. This 'home country bias' limits many investors' utilization of emerging markets in their portfolios.
We suggest this is a very good time for these folks to get past that predisposition. Why? Because beyond their quantifiable diversification benefits, emerging market assets are poised to benefit from the expected economic growth in the underlying countries. Stocks in these regions remain highly sensitive to drops in risk appetites, of course—2011's third quarter, for example—but we think an institutional-grade asset allocation strategy should consider a commitment to the space.
From a portfolio construction perspective, both the relatively low R-squared of emerging market equities and the category's historical performance are both highly attractive attributes. As for the diversification benefits of the asset class, over the last 10 years the rolling three-year R-squared between the Russell Emerging Markets Large Cap Index and the S&P 500 has averaged 0.69. From a performance perspective, Prima's research found that an investor with a 60/40 allocation to the S&P 500 Index and the Barclays Aggregate Index over the last 10 years would have picked up 42% in performance and a marginally higher Sharpe Ratio by simply substituting 20% of the S&P 500 allocation with the Russell Emerging Markets Large Cap Index.
What About EM Investing in the Future?
As attractive as these historical statistics are, a forward-looking assessment of the regions' economic fundamentals may be even more relevant and convincing. Most of the portfolio managers we speak with believe that a combination of favorable demographic trends, increased urbanization, and the rise of the middle class in the emerging markets will result in economic growth that will far outpace that of the developed world.
In an investment context, that means that an investor who only allocates capital to advanced economies will be limited to regions marked by relatively low growth prospects. How low? According to estimates by the International Monetary Fund (see chart on left), the GDP growth rates of emerging economies will be nearly three times those of the advanced economies over the next several years.
Further, and as a direct result of this growth, the IMF projects that emerging economies will actually surpass the cumulative value of advanced economies and become a majority of global GDP by 2013,
