Emerging markets as an asset class have fallen out of favour over the past decade, primarily due to poor relative returns and concerns over governance within constituent countries.
This article takes an objective approach to assessing emerging markets, steering clear of the opinion-based forecasting that often dominates discussions on the topic. Importantly, it will also highlight how data can be manipulated to support a particular narrative, something that any good investor must understand. However, as with any analysis, the line between objectivity and subjectivity is not always as clear as it seems.
What are Emerging Markets?
Emerging markets refer to countries that are not yet considered fully developed economically. These nations are typically experiencing rapid economic growth, and the assumption is that companies within these economies should benefit from this expansion, presenting attractive investment opportunities.
As of 2024, MSCI (a major research firm) classifies the following economies as developing or emerging:
Since the early 2000s, fund managers have offered exposure to these stock markets through specifically branded ‘emerging markets’ investment funds.
The premise is that while emerging markets carry additional geopolitical, liquidity, and currency risks, these should be outweighed by higher returns compared to more developed and stable economies.
In theory, investing in emerging markets offers a chance to gain early exposure to the dominant countries and companies of the future. But has this been reflected in historical returns?
Assumptions
The returns displayed in this article are sourced from the following benchmark indexes:
These indexes are generally reflective of the benchmarks followed by passive funds and ETFs that invest in these asset classes. The data is correct as of 28/02/2025.
Poor Returns
Let’s examine the annual returns of these investment options over the past 10 years.
Emerging markets have clearly underperformed during this period. Even compared to Australian shares, generally considered a much lower-risk investment, returns have lagged significantly.
If you had invested $1,000 in each of these options a decade ago, the underperformance of emerging markets would be painfully evident.
This is why many passive investors avoid emerging markets. The long-term returns simply don’t seem to justify the additional risks associated with the asset class.
Long-Term Performance
One common mistake is assuming that 10 years of performance data is sufficient to evaluate an investment. In most cases, this timeframe might capture just one boom-and-bust cycle, if that. Making investment decisions based on a single decade of data is far from ideal, as the following graph will demonstrate.
Looking at data since 1988, the earliest available for the emerging markets index, the 10-year performance trend is completely reversed. Over a 40-year period, it is actually the global share market that appears to be the poorer investment choice. Choosing global shares over emerging markets would have resulted in nearly $10,000 less by 2025.
This anomaly highlights the well-worn phrase: past performance is not an indicator of future performance. More importantly, it underscores how data can be used to support a particular narrative.
Past performance can be useful when comparing similar investments, such as an active fund against its index benchmark. However, it is largely irrelevant when comparing different risk-based asset classes, as returns are entirely dependent on market conditions at the time.
For example, Australian shares performed exceptionally well in the mid-2000s due to the mining boom. Similarly, U.S. shares dominated in the 2020s, driven by the rise of big tech. If past performance reliably indicated future returns, it would suggest a predictable cycle of outperformance. But markets are driven by the economic environment, population trends, and government policies, factors that are unique to each period. This makes sustained cyclicality impossible.
Relying purely on past performance, particularly given how easily it can be manipulated by selecting specific timeframes, is not a sound basis for portfolio construction. For emerging markets, this is especially evident.
Risk
If past performance is largely irrelevant, how else can you determine whether investing in emerging markets is a good idea?
The financial industry often refers to risk-adjusted return. This is a measure that normalises long-term returns to account for the level of risk incurred. In this context, risk generally refers to volatility. Higher volatility is typically seen as less desirable, so investors expect higher returns to compensate for it. Risk-adjusted return helps evaluate whether an investment has delivered sufficient reward for the level of risk taken.
Whilst nominal performance may not be a useful guide, a higher-than-average risk-adjusted return could suggest that emerging markets are indeed a worthwhile investment.
Sharpe Ratio
The most widely used measure of risk-adjusted return is the Sharpe ratio.
The Sharpe ratio calculates an investment’s return above a risk-free rate, the assumed return of an investment with virtually no risk. This is generally considered to be the central bank’s cash rate. For this calculation, the AusBond Bank Bill Index has been used, which has delivered an annual return of 5.41% since 1988.
The formula is:
Standard deviation measures the strength of an investment’s volatility over a given period. A higher Sharpe ratio indicates that an investor received more return for the level of risk taken, meaning a higher ratio is preferable.
Using data from 1988 onwards, the Sharpe ratios for our asset classes have been calculated below:
As expected, emerging markets exhibited higher volatility (standard deviation). However, what may be surprising is that this additional risk was not necessarily compensated with enough extra return.
Interestingly, over this period, Australian shares delivered the best risk-adjusted return of the three options.
Diversification
So far, emerging markets appear to be a relatively poor investment prospect. However, there is one final justification for including them in a portfolio, one that does not rely on opinion-based forecasting.
This argument is diversification. The idea is that emerging markets should not move in perfect sync with standard global shares. If their performance is less correlated, then when global shares underperform, emerging markets might be outperforming, and vice versa. This could help smooth out overall portfolio returns, even if each individual investment is volatile.
Correlation Coefficient
The relationship between two investments can be measured using the correlation coefficient, a value between -1 and 1:
- A coefficient of 1 means two datasets are perfectly correlated; they move in lockstep with each other.
- A coefficient of -1 indicates a perfect negative correlation, when one rises, the other falls by the same amount.
- A coefficient of 0 suggests no relationship between the datasets.
Let’s examine the correlation between Australian shares, global shares, and emerging markets.
The resulting coefficients fall within the 0.4 to 0.6 range, suggesting a moderately strong relationship between these asset classes.
For comparison, Australian Government Bonds have a correlation coefficient of 0.09 with Australian shares, indicating a much weaker relationship.
Pairing assets with a 0.4 – 0.6 correlation may provide some diversification benefits, though not as much as pairing assets with near-zero or negative correlations.
So, No to Emerging Markets?
Not necessarily. This analysis has focused on an index-based approach to emerging markets, which is somewhat controversial. Many argue that active management is the better approach for this asset class. For an outline of active vs passive, this is a previously published article on the topic.
Active managers often point to the added geopolitical risks, lower market efficiency, and lower liquidity of emerging markets as justification for their style of investing. While they may concede that developed markets, due to their size and efficiency, are better suited to passive management, they argue that the smaller, less liquid markets within the emerging universe provide an opportunity for active strategies to outperform.
However, like many justifications for active management, these claims are not well supported by actual returns. The most recent SPIVA study for U.S-based emerging market funds shows that nearly 70% of them underperformed their benchmark over a five year period.
Subjectivity vs Objectivity
Based on this analysis, there appear to be few objective reasons for including emerging markets in a portfolio, yet these investments continue to attract capital. Why?
As we know, past performance is no indicator of future performance. But if an investor believes that the dominance of U.S. capital markets will decline over the coming decades in favour of economies like China, Brazil, and India, they may justify an allocation to emerging markets.
This is ultimately a subjective view of the future, but it is one that can be reasonably argued. But so can the counterargument.
Conclusion
This article is not intended as a definitive argument for or against investing in emerging markets. Rather, it highlights that, despite the passive investment philosophy’s aim to introduce objectivity and impartiality, some level of subjectivity is always unavoidable.
Every investment decision is also a decision not to invest in something else, or to hold cash instead.
This subjectivity extends beyond emerging markets. For instance, the justification for the common 70% global / 30% Australian portfolio allocation is based on past returns. But if past performance is irrelevant, should this justification still hold?
The future performance of emerging markets is likely to be shaped as much by geopolitics as by the success of individual companies. If you believe that global economic leadership may shift towards emerging economies, these markets could present a compelling opportunity. If not, a broad large-cap global allocation may be all that is needed for you personally.
If history is any guide, investors are unlikely to be severely punished for choosing either path.
