Michael Mauboussin documents a number of good reasons why the investment industry has become more short-term oriented. Not too long ago we had a post up on how investors might take advantage of this short-termism. Time arbitrage allows longer term investors to take advantage of short term distortions. This becomes all the more important when one invests a portion of their portfolio overseas, especially in the more volatile emerging markets.
CXO Advisory Group highlights a paper by Javier Estrada that attempts to model long term return expectations in a number of developed markets. Although the model is a relatively simple one it does distinguish some key drivers for returns, including expected earnings growth and expected change in P/E ratios. What we found surprising was the relatively large spread in decade long returns among a dozen countries. The post is well worth a look.
What would be really useful would be a model that also encompasses the emerging markets as well. Given the model construction that is impossible for a lack of meaningful historical data. One need only look at the volatility in the Latin American markets to see the potential benefits for a scalable model. Shefali Anand and Alistair MacDonald in the Wall Street Journal document the drivers behind the roller-coaster ride that is Latin American equity mutual funds.
The strongest argument for the emerging markets at this point is that they remain less expensive than their developed market counterparts. This is an argument also favored by Jay Walker at the Confused Capitalist. Jason Leow in the Wall Street Journal notes that in a number of major emerging markets P/E ratios hover not much above 10x. While we are generally skeptical of arguments based on raw P/E ratios they can give some sense for relative valuation. Our supposition is that if you were able to apply the Estrada model to the emerging markets you would find on average higher expected returns than the developed markets.
Recent global market volatility has not slowed the interest of fund companies in launching new international equity funds. Eleanor Laise in the Wall Street Journal focuses on a new international value fund, a global real estate index fund, and the long-awaited launch of a BRIC fund. Most investment advisers would recommend individual investors utilize broader based emerging market funds as opposed to more concentrated vehicles like a BRIC fund.
Jonathan Clements also in the Wall Street Journal looks at how some latecomers to the emerging market game have been hurt by the most recent downturn. Clements argues that most investors would be better served by having an established investment policy that includes regular re-balancing. We are also a fan of this approach and does allow for investors to balance the short-term and long-term needs of their portfolio.
Re-balancing allows investors to benefit from the differential performance of various asset classes in their portfolio. During this most recent period of emerging market strength investors would have allowed to their weightings in the emerging markets to rise up to a certain point before taking profits. On the flip side when an asset class is underperforming one needs to invest more to bring the weights back up to target.
This re-balancing process is a disciplined one that depends in the long run on some measure of mean reversion to occur. There are indeed good long term arguments in favor of the emerging markets, but one must approach them with a solid plan in place, because the intervening volatility will take its toll on your investment psychology.