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Surprising Pick for Safety, High Returns: Emerging Market Stocks

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Though apt to lurch violently from boom to bust, emerging markets stocks do produce higher returns over time — but are they worth all the portfolio whiplash your clients must endure?

Actually, yes — if the advisor orchestrates the client’s portfolio intelligently — according to Servo Wealth Management’s Eric Nelson most recent blog post.

On the face of it, whether emerging market stocks enhance an investor’s portfolio is a legitimate question.

That is because their volatility is of such a higher magnitude that one might think to enhance portfolio returns without nearly as much added risk.

Specifically, Nelson cites the Dimensional Fund Advisors emerging markets value fund’s standard deviation of 27 over the past 16 years; that is close to twice the volatility of DFA’s U.S. large growth portfolio (based on the S&P 500) whose standard deviation was just 15.8 over the same period.

An advisor might rationally seek to improve portfolio return by adding large value stocks, small value stocks, international large value or international small value stocks. All of these had higher returns and higher risk than the S&P 500, but their standard deviations were 19, 21.5, 19.7 and 18.5, respectively.

The riskiest of that bunch, U.S. small value, was around halfway between the S&P 500 and an emerging markets value fund in terms of standard deviation. So one might think twice about staking a position.

Put differently, should a portfolio include emerging-markets value stocks — whose average annual return over the past 16 years was a whopping 12.4% — when adding international small value, which returned 10.8% over the same period, nearly matches the return advantage with so much less risk (18.5 vs. EM’s standard deviation of 27)?

The surprising answer is yes, and the reason Nelson gives is that “investors don’t buy positions, they own portfolios.”

The Oklahoma City-based fee-only advisor demonstrates the magic of diversification by comparing an all-stock developed markets portfolio (70% U.S., 30% international) returned, over the past 16 years, 8.6% annually with a standard deviation of 17.8.

Yet a similar 70-30 mix, this time including emerging markets (in addition to international large value and international small value), returned 9.2% with a standard deviation of 18.3.

Writes Nelson:

“The return increased by 0.6% per year, while the standard deviation (risk) of the portfolio only increased by 0.5%.  Over a period of more than 15 years, a 0.6% per year higher return would lead to $0.38 more wealth for every $1 initially invested, while a half-percent increase in volatility is almost unnoticeable.”

Practically a free ride.

And Nelson finds another implication for safety-seeking investors. By rearranging the portfolio to include a 15% allocation to high-quality short-term bonds but by including just an 8.5% stake in emerging markets (within the 85% stock portion of the portfolio), an investor would earn the same 8.6% return as the developed-market-stocks-only portfolio, but with a standard deviation of just 15.5 rather than 17.8.

Whether maximizing returns or limiting volatility is the goal, emerging markets stocks seem poised to help long-term investors, Nelson concludes.

But beyond the principled basis for their inclusion, ThinkAdvisor asked if their poor recent performance further strengthens the case for emerging market stocks.

“You don’t have to be a market timer to realize that emerging market returns have been negative or in the low single digits for the last several years, so they’re cheaper on a relative basis,” Nelson says.

“I wouldn’t be surprised if over the next 3 to 5 years, emerging markets stocks do several percentage points better than U.S. stocks because that’s how things work,” he adds in a nod to the mean reversion investing principle.

“So the long-term case for including them in a portfolio is there,” he says. “And as to the short-term basis, there’s almost no case I can think of for excluding them right now. So you have all your bases covered.”

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