Emerging markets: Innocents abroad?

Posted by on October 20, 2010 @ 8:56 am in Investing

Mark Twain lost a couple of fortunes through bad investments, which probably explains the pungency of his comments about investing.

Such as: “There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can.”

I’ve always thought investors should keep in mind another Twain observation: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

Just a few years ago, legions of borrowers and investors and lenders knew “for sure” that there was no way U.S. housing prices could fall much, if at all. We know how that turned out. Sometimes, the things we know for sure actually are true, but the conclusions we draw from these facts are what “just ain’t so.”

For example, everyone could see 10 or 12 years ago that the internet was a hugely important development in the way people were communicating, buying, and conducting business. The explosion in web-based commerce was certainly true. What just wasn’t so was the belief that all this growth made investments in internet companies a sure thing.

I wonder whether a parallel today is emerging-market stocks?

It’s a fact that emerging-market economies are growing much faster than developed economies such as the U.S., Europe, and Japan. And these emerging economies are widely expected to continue growing faster.

What doesn’t necessarily follow is that more-rapid growth in emerging markets will result in higher returns from emerging market stocks. Vanguard’s chief economist, Joe Davis, made this point in a recent research paper. In brief, Joe’s research finds that there has been no correlation in the past between the growth rate in a given country and the performance of stocks in these countries. That finding may seem counterintuitive, but it’s not so surprising when you realize that some of the economic growth in a given country is supplied by multinational firms.

What makes this matter of more than academic interest is that a lot of money is flowing these days into emerging-market stocks. According to data from Vanguard and the mutual fund researchers Morningstar, 97% of the net cash flowing into international stock mutual funds over the 3 years through August 31 went into emerging markets funds—$87.9 billion out of $90.5 billion. (I cadged this fact from a research paper by my colleagues Chris Philips, Fran Kinniry, and Yan Zilbering.)

If the big inflows represent thoughtful decisions by investors to increase the allocation to emerging markets in their long-term investment plans, perhaps there’s nothing to worry about. Indeed, analysis we’ve done at Vanguard underscores our belief that U.S. investors should consider an international exposure of 20% to 40% of the stock portion of their portfolios.

But to me it’s worrisome that these flows follow several years in which emerging-market stocks have outperformed stocks in the United States or in developed international markets. We’ve seen such patterns many times in the past—cash flow into mutual funds tends to follow strong performance in a particular category—and the results are rarely good for investors.

To the extent that investors are chasing the relatively strong returns from emerging-market stocks, I hope they’re not being, to borrow again from Mark Twain, Innocents Abroad.

Note: All investments are subject to risks. Foreign investing involves additional risks including currency fluctuations and political uncertainty. Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

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