The flow of funds out of U.S. equities and international equities—particularly emerging markets—is well documented, and emerging markets have outperformed as an asset class over the 10 years ended Aug 31, according to a new research paper from Vanguard, “Are Investors Truly Embracing International Diversification?” by Christopher Philips, Francis Kinniry Jr. and Yan Zilbering.

But even as the paper encourages diversification of equity allocations and a more global investing perspective, it cautions that the “speed and magnitude” of the flows into emerging markets equities over the latest three years and the “apparent positive correlation between trailing returns and cash flows,” might lead investors to expect returns like these to continue and that this could be “unrealistic.”

A Higher Proportion of International Equities in Emerging Markets

The report explains that, “allocations to stock funds investing abroad now account for 30% of all U.S. equity mutual fund holdings,” nearly double the international equity allocation of a decade ago. The authors assert that, “we believe that investors should strive to be more diversified rather than less, and Vanguard suggests that most investors consider allocating 20%–40% of their equity holdings to stocks abroad.”

Their analysis shows that as of August, investors have allocated just over 30% of their equity holdings to international equities, close to what they’d allocated internationally in Dec. 2007, but within the international mix, the current allocation to emerging markets is higher. “We also believe that, within an allocation to non-U.S. stocks, countries and regions should be represented in proportion to their global market-capitalization weightings.”

As has reported, the Vanguard paper confirms that net flows to emerging markets have been remarkable. Flows “to non-U.S.-focused funds were significantly positive,” for the one-, three-, five- and 10-year periods ending August 31. For the one-year period, 66% of cash

flowing into international markets went to emerging markets, as did 97% for the three-year period, the report states. Over the longer term, those numbers are much lower: for the 10-year period, 25% of cash going to international equities went to emerging markets, while for the five-year period, 30% of that international flow went to emerging markets.

Acknowledging that domestic U.S. markets suffered in the past three years as growth continued in emerging markets, authors of the paper note that now, caution may be in order: Citing a Vanguard research paper by Joseph Davis, Roger Aliaga-Díaz, C. William Cole, and Julieann Shanahan, “Investing in emerging markets: Evaluating the allure of rapid economic growth,” they assert that “strong economic growth does not necessarily lead to exceptional stock returns.” They further warn that, “there is zero historical correlation between economic growth and a country’s stock market returns.”

Are Emerging Markets Still Undervalued?

In fact, “Are investors truly embracing international diversification?” notes a “systematic tightening of valuations between developed and emerging markets. In other words, relative to the U.S. market, emerging markets were undervalued in the early 2000s, whereas they tend to be more similarly valued today.”

Will assets stick in emerging markets or sprint back to U.S. domestic equities? It is the “speed and magnitude of the reallocation to emerging markets,” during the last three years—coincident with the markets crisis—that concerns the authors, and though they encourage diversification, they are wary that once the U.S. market begins to perform well again, investors may bring some of their international allocation back to domestic markets, thereby depriving emerging markets with the inflows engine that may have added fuel to its performance.