From the January 2007 issue of Wealth Manager Web • Subscribe!

January 1, 2007

The Big Chill

Emerging markets equities have been a hot investment in the last few years, but a review of the longer run has cooled Jeffrey Troutner's enthusiasm for the asset class. The chill is notable because the president of TAM Asset Management in Tiburon, Calif. was an early proponent of owning developing-country stocks. As Troutner recently told Wealth Manager, he started adding emerging markets to client portfolios in the mid-1990s--about the time the asset class began attracting mainstream attention for the first time.

But the allure is fading for Troutner, whose advisory business oversees $150 million. He detailed his disappointment in the August 2006 issue of his newsletter Asset Class, which is available on the firm's Web site, TamAsset.com. The source of his regret: Mediocre returns for emerging markets over the long haul, namely for the 12 years through the end of 2005, he explained. Meanwhile, correlations between emerging markets and the U.S. stock market have been rising, and volatility has stayed high. The asset class, he sums up, has fallen considerably short of expectations.

Troutner is a fan of Dimensional Fund Advisors (DFA), which embraces passive money management with a value and small-cap equity tilt informed by research from Professors Eugene Fama and Ken French. Troutner currently taps developing-market stocks via DFA Emerging Markets Fund for client portfolios, although he's looking for rallies for selling out the positions.

In fact, DFA isn't exactly enthused with foreign stocks these days either. In the firm's Quarterly Institutional Review for the third quarter of 2006, the publication asserted that even foreign developed-market stocks don't provide enough diversification to justify investing from a U.S. perspective. Cited as an example are the high correlations between MSCI EAFE and the S&P 500. On the other hand, international small and value stocks look more attractive, the DFA newsletter stated.

Troutner agrees, as he explained in greater detail during a recent interview with Wealth Manager.

How did you come to reconsider emerging markets as an asset class?

It was prompted by the drop in emerging markets after this year's first quarter, which coincided with a drop in the S&P 500. The drop got me wondering: What kind of diversification benefit do emerging markets provide? So I looked at the numbers.

Then someone sent me a link to Bill Bernstein's recent article on emerging markets for Brazil, Russia, India and China ["Thick as a BRIC" at Efficientfrontier.com]. The idea is that BRIC countries are high-growth economies, and so investors should expect them to deliver high returns. In fact, we've seen low returns associated with high-growth economies. Bill raised some doubts about BRIC as an investment and the association of high-growth economies with high stock returns.

Bill also mentioned something that we already know--meaning those of us who use DFA funds and are familiar with the Fama/ French research. Growth companies provide the lowest returns. The reason, from our perspective, is one of risk: Growth companies tend to be less risky, and so their prices are higher, and therefore their expected returns are lower. But in the minds of a lot of investors, high growth means high return. But that's not the case.

Investors don't think about the fact that bidding up the prices of high-growth investments lowers expected returns. Bill talks about that in the context of emerging markets. A lot of capital has gone into these markets in anticipation of higher growth, and that's driven up prices and therefore, expected returns are lower. In fact, that's what we may have seen since 1994. People are buying into emerging markets based on how well they did in the previous years. Meanwhile, emerging markets still come with a lot of volatility.

Is the high volatility surprising?

No. You expect the volatility from emerging markets, because it's inherently riskier [than domestic stocks, for instance]. But you also expect higher returns; but we haven't gotten that with emerging markets. No investor in their right mind would, for very long, put up with high volatility and low returns. On the other hand, I can invest in U.S. small value stocks and get almost as high returns with half the volatility of emerging markets.

Emerging markets may have fallen short of expectations, but the asset class is hardly a washout.

Emerging markets did, in fact, deliver a total return from 1988 through 2005 of 18.1 percent [annualized]. That was better than international small value, for instance, by over six percentage points more per year. But emerging markets volatility was over 40 percent during 1988 to 2005, while the international small value standard deviation was about half that level. So, emerging markets are a much more volatile and risky asset class.

Most people in my position will say that's fine, because emerging markets also had a relatively low correlation to the U.S. equity market. You put up with the high volatility because of the low correlation to U.S. stocks. Using emerging markets in a portfolio lets you moderate the volatility; meanwhile, you're getting a diversification benefit.

The problem is, everything changed from 1994 on. We received low returns from emerging markets from that point and we still got high volatility. Meanwhile, correlation [between emerging markets and the S&P 500] on a monthly basis rose, jumping from about 0.25 in 1988 to 1994 to about 0.67 in 1994 to 2005. In fact, the correlation has been really high in the down markets--a point when we really needed emerging markets to step up and act as a diversifier. But when the U.S. market fell, emerging markets were almost always down as well, and for longer.

Why did emerging markets stumble after 1994?

In 1994, DFA and Vanguard launched their emerging markets funds. I would argue that the hype for emerging markets started to accumulate around that time. There's a lot of hot capital flowing in and out of those markets. It's flighty capital. There's a hell of a lot more investors in U.S. stocks than speculators on the whole; but in emerging markets, there are far more speculators than true investors. When the U.S. market drops, and the outlook for the U.S. market isn't good, people get skittish. They not only sell their U.S. stocks, they also start pulling out of the really risky asset classes like emerging markets.

Wall Street really starting pumping emerging markets in the mid-1990s. And why not? From 1988 to 1993, emerging markets returned 45 percent per year. Wall Street doesn't miss an opportunity to market, and so when there's an animal that did 45 percent a year, the Street's going to market the hell out of it. But for the next 12 years through the close of 2005, emerging markets did 6.5 percent a year with just about as much volatility as they had in the previous period.

What measure of emerging markets are you citing?

The DFA Emerging Markets index.

Does the history look any better with MSCI Emerging Markets, which is a more widely cited benchmark?

The DFA Emerging Markets index has done 6.5 percent [from January 1, 1994 through December 31, 2005], and the MSCI Emerging Markets, with dividends included, returned an annualized 4.7 percent. So the DFA index did better. They both go back to 1988. DFA's index has done 18.1 percent versus 14.3 percent for MSCI for 1988 through 2005. So the argument [for emerging markets] doesn't get any better with MSCI Emerging Markets.

For all of emerging markets' failings, isn't it true that every asset class stumbles at times.

Granted, there are going to be periods when small value stinks, too. That's the nature of risk. We expect that. But with emerging markets, it's not just that we've gone through a bad period [1994-2005], but that we've also seen correlation increase while volatility stayed high. After putting all the pieces of the puzzle together, I started asking: Why do I own this? Because Wall Street says we should? Because some authors say we should own emerging markets? That's nuts.

How does the world of foreign developed-equity markets compare--MSCI EAFE, to cite the obvious benchmark?

The S&P 500 and EAFE generally have the same expected return because the cost of capital for large companies in the U.S. is the same as the cost of capital for large companies in all the developed nations. And if you look at long-run returns between the S&P 500 and EAFE, it's uncanny how close those returns are. But we know that they're not perfectly correlated, and so we get some diversification benefit.

The correlation between the S&P 500 and EAFE bounces around a lot over time.

Yes, it does. But because people like me have access to very good large international value, small international value, and small international equity funds from DFA, we actually get better diversification benefits by going to value and small cap on the developed side. When I put together a portfolio for clients, I don't usually use EAFE; instead, I'll have international large value and international small value. So I'm still getting better diversification benefits and a higher expected return compared to using EAFE.

The point is that you can obtain better international market diversification if you tilt more toward value and small cap because those asset classes aren't as highly correlated to the U.S. market as EAFE is. And you get a higher expected return, because you're taking on greater risk: small-cap and value risk.

How did a DFA and Fama/French devotee rationalize emerging markets in the first place?

It's a "cost of capital" argument. In the Fama/ French research, you don't find mention of emerging markets, but you do find mention of the cost of capital. They believe that small cap beats large cap, and value beats growth because it's a cost of capital argument; it's a risk story. So, it's logical to use the cost of capital argument when you're talking about emerging markets. It's logical that companies in emerging markets have a higher cost of capital than companies in the developed markets. If that's true, then the other side of the cost-of-capital equation is return on capital: You should get a higher return because these companies have a higher cost of capital.

Ok, so higher risk leads to higher returns. If that holds true in the developed world, it should hold true in the developing world, although the Fama/ French research doesn't formally address the subject.

Exactly. In fact, emerging markets doesn't really fit the Fama/French story because the data is way too short, unreliable, and you don't have access to good accounting data like you do in the developed markets.

Do you have emerging markets exposure in client portfolios?

I still own the DFA Emerging Markets fund because DFA's very picky about what to include in the portfolio. But I'm also asking the question: Should we continue to invest in emerging markets? My inclination is to answer "no." Emerging markets are on a watch list for me; they're on probation. So, when new clients come to me, and we talk about emerging markets, it's likely that we won't include it in the portfolio. With existing clients, I watch emerging markets, and if we go through a period when returns are strong, at some point we'll get out.

So, you're persuaded the asset class isn't useful as a long-term holding?

That's right, and it's not just because I'm looking at the returns and correlations over the last 10 or 12 years. It's because emerging markets introduce a whole set of other risks: political, social, legal, you name it. Emerging markets have unique risks. Take China. It's still a communist nation and doesn't have a fraction of the respect for the rule of law that's found in this country or in the developed international markets.

What do you say to a client who points out that emerging markets have done well since 2003? Do such clients pose a marketing or education challenge?

It could be an education challenge. But people don't hire me to make decisions based on recent returns or to make decisions based on what Wall Street says I should put into portfolios. I'm not a seller of product; I'm an investment advisor with one interest: do the right thing for my clients. If I deem there's a better alternative to emerging markets, which could very well be international small value, then I'll make that decision.

James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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