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  • Home>Research & Insights>Phillips Curve>Emerging or Emerged?

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    Emerging or Emerged?

    Is it fair to question whether the past diversification benefits of emerging markets still hold?

    Don Phillips, 12/21/2016

    At a financial planning conference in the mid- 1990s, I saw a top asset-allocation expert announce that her firm had recently made the decision to ignore bond-market returns before 1971, which is when President Nixon took the United States off the gold standard.

    To her firm’s reasoning, that change inaugurated a new era of bond volatility, and the stable returns of the 1950s and 1960s could no longer be expected. The new reality for bond investors would be more like the tremendous volatility witnessed in the 1970s and 1980s.

    This revelation, humorously 20 years after the fact, implied that any asset allocation derived from the now-discredited earlier numbers needed to be adjusted. But in a broader sense, it reminds us that the character of asset classes can change over time and that the lessons of the past may, at times, need to be adjusted. Sometimes the past is not prologue. Perhaps, such lessons apply to emerging markets today.

    Twenty years ago, emerging-markets and smallcap stocks were very much intertwined in investors’ minds and with good reason. Portfolio managers spoke of the smaller, more focused companies they found in emerging markets and often praised the potential of these smaller companies to be acquired by global behemoths swooping in from more developed markets.

    The numbers bolster this impression. In 1996, Vanguard Emerging Markets Stock Index Fund VEIEX had a median market-cap of just over $4 billion, which was roughly one third that of the broader international indexes. Many leading emerging-markets funds of the era, like those from Fidelity and Templeton, had median market caps that were less than half that of the emerging markets’ indexes, often less than $2 billion, lending a distinct small-cap tilt to the category as a whole.

    The numbers bolster this impression. In 1996, Today, however, the situation is very different. The median market cap of the emerging-markets index now clocks in at close to $14 billion, and it no longer differs as greatly from the broader international index. In 1996, two thirds of the emerging-markets index placed in our small- and mid-cap buckets; today more than 80% of the index qualifies for our large- or giant-cap categories. That’s a dramatic shift. In terms of size, emerging markets are no longer synonymous with small-cap stocks. Today, they offer another shade of large, especially if you get your exposure to them through capitalization-weighted indexes, which naturally skew toward larger names.

    Sector exposure has also changed considerably. It’s no longer just banks, beer, cement, and telephones that dominate emerging-markets portfolios. In the 1990s, these funds had dramatic overweightings in utilities, finance, and consumer durables and little to no exposure to technology and healthcare. It was a very different profile than the broader international markets, one prone to far greater cyclicality and different boom-and-bust patterns than the broader market. That’s likely one of the things that gave diversifying potential to the category.

    Today, the picture is much different. Tech has gone from roughly 5% to around 20% of the average emerging-markets fund. Utilities exposure has fallen more in line with broader averages. Emerging markets now look more and more like the rest of the world, with the notable exception of much less healthcare exposure.

    Don Phillips is a managing director of Morningstar, Inc.