The time for emerging markets is now — if you can stand it

If your clients have an emerging markets fund in their portfolio, they probably have a few questions for you. They might, for example, be wondering why you hate them, or whether you’re still sniffing glue.
As well they might: The average emerging markets fund has swooned 9.91% this year, according to Morningstar. The rout in emerging markets raises the question: Are they worth the pain? For long-term, buy-and-hold investors, the answer is fairly ambiguous: The good times don’t always outweigh the bad. But if you like to buy cheap — and your investors won’t smack you for suggesting it — right now might be a good time to look at emerging markets.
Most people own emerging markets stocks because those economies tend to grow faster than those of industrialized nations. And this is true. U.S. gross domestic product grew at a 2% pace in the third quarter. In contrast, Chinese GDP grew at a 6.8% annual rate in the fourth quarter, a pace the Chinese classify as “moribund.”
Unfortunately, emerging markets also tend to slow faster and harder than those of industrialized nations, as we’ve seen recently. And this means bigger slides for their stock markets. Japan’s stock market has tumbled 10.5% this year in dollar terms, for example, but China’s A shares have plunged 17.8%, according to MSCI.
For those who are trained to be long-term investors, it’s difficult to see from this vantage point just how much good you’re getting from emerging markets. Emerging markets have lost an average annual 0.85% the past decade, according to MSCI, while the developed world has gained 1.53% a year. MSCI’s U.S. index has gained 4.02% the past decade.
And this is not terribly unusual. At least in nominal terms, U.S. stocks fared better as a developed market in the 20th century than they did the 19th century, when it was an emerging market. U.S. stocks gained an average 6.51% in the 19th century, according to William Bernstein, vs. 9.98% in the 20th century. (Adjusted for inflation, the deflationary 19th century had a slight edge).
While the 20th century had its shares of war and other unfortunate events — World War II and the Great Depression come to mind — so did the 19th century. The 1836 panic and depression kept economic growth so sluggish that the next decade was nicknamed “the hungry 40s.” The Civil War devastated the country: Wars are always tougher for the economy when they’re fought on your own soil.
Then there’s the problems of corruption and market manipulation, still endemic in places like Russia and China. Picking stocks is hard enough without trying to figure out which companies the local strongman favors. Remember Lukoil? Russia’s largest oil company had its shares frozen in October 2003 as part of Vladimir Putin’s quarrel with chief executive officer Mikhail Borisovich Khodorkovsky, who subsequently served a lengthy prison term.
Typically, it’s foreign investors who get overly excited about the prospects of emerging markets. Foreign investors routinely got smacked when investing in America’s canals and railroads in the 19th century. Similarly, it was mainly U.S. investors who got swept up into the Asian Tigers boom and bust in the late 1990s. It’s much easier to be optimistic about countries when you’re observing them from a four-star hotel room.
Nevertheless, emerging markets are dead cheap now, and if your clients are willing to forgive you for the past 12 months, this is a good time go back in, says Rob Arnott, chief executive officer of Research Affiliates. Currently, he says, emerging markets are nearly as cheap as they were at the bottom of the Asian currency crisis in 1998.
Right now, some of the cheapest emerging markets are cheap because of the plummeting price of oil. “Could it get cheaper? Sure. Do I want to pick the bottom? No,” he says.
Emerging markets stocks are particularly cheap now, especially compared with emerging markets value stocks, Mr. Arnott says. “It’s a wonderful time to ramp up exposure,” he says. One way to do so would be through a traditional value fund, such as the beaten-down Templeton Foreign (TEMFX). Another way would be through a fundamentally weighted index fund, such as Schwab Fundamental Emerging Markets Large Company Index ETF (FNDE). (And, yes, the Schwab fund uses methodology developed by Research Affiliates).
Arjun Jayaraman, portfolio manager of Causeway Emerging Market fund, suggests looking at markets that are net oil importers, rather than exporters. “Emerging markets are no longer an exporter story,” he says, pointing out that 72% of the MSCI emerging markets index is in Asia, whose countries are mainly oil importers. “There’s not going to be a V-shaped recovery in oil,” Mr. Jayaraman says. “The economies that will benefit the most from low oil are places like Taiwan and Korea.”
Investing in emerging markets now means buying into the area that has made your clients shout your name when they step on a rake. But that’s often the best time to buy.