Emerging Markets: Caution, Not Abstinence

In the space of three years, emerging markets (EM) have gone from a key strategic asset class, one favored by many investors, to persona non grata. More than $10 billion flowed out of emerging market exchange traded funds (ETFs) in 2013, a level already exceeded during the first two months of 2014.

While we share investors’ concerns on the near-term outlook for emerging market assets, we disagree with the notion that EM has gone from a strategic asset class to one that should be completely shunned.

Many investors are being scared off by the volatility in emerging markets, but it is important to note that recent volatility is not abnormal. The recent past is actually more representative of EM investing than the unusually placid period of the past several years, a period in which markets were unusually quiet due to unconventional monetary policy by the major central banks.

The reason investors have historically put up with this high volatility is that over long periods of time, EM stocks and bonds have benefited most portfolios. While EM assets are more volatile than those in developed markets—one of the main reasons EM allocations should be modest—they still provide some diversification and generally are additive in moderate or aggressive portfolios.

And while it is true that the short-term outlook for emerging markets does suggest further volatility, even today investors may want to consider targeted purchases. In particular, in a world in which low yields still prevail, we see relative value in EM dollar-denominated bonds. On the equity side, we see significant opportunities to differentiate among EM countries, sectors and stocks. As such, the current environment is one in which we see rich pickings for active managers with broad mandates.