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How Much Should We Invest in Emerging

May 28, 2015
by Dr. Burton Malkiel
of WaveFront Capital Management
Investors today are significantly underexposed to emerging markets; fortunately, the
opportunity to correct this flaw is the best in years.
One of the most enduring and perplexing behavioral biases in investing is called The Home Country
Bias. Despite the availability of well-regarded and highly profitable corporations located through the
world, investors have tended to limit their investments to companies domiciled in their own country.
At one time, a survey of institutional investors in France found that 97 percent of their equity
investments consisted of French companies despite the fact that France represented only 3 percent
of the worlds total equity capitalization. There is a strong tendency for investors to regard
international stocks as risky, and this is especially the case when it comes to emerging markets.
Emerging markets do indeed present additional risks, but they are less risky than they used to be.
Many investors still remember the dramatic crisis in 1998, and the terrible losses suffered by equity
investors as P/E multiples compressed to low single-digit levels. I certainly remember it; in fact, I coauthored a book on emerging markets that year called Global Bargain Hunting. Investors hoping for
a repeat episode of 1998 are likely to be disappointed, however. A lot of corrective action was taken
by governments everywhere at the time, and their economies and capital markets have progressed a
great deal since then. A similar crisis is unlikely today.
While most investors are aware that these markets are growing, few realize just how large they have
already become. It also pays to remember that, within a global stock portfolio, the diversification
benefits of adding emerging markets could actually reduce your overall risk. More importantly, I think
it will improve your returns in the years ahead: valuations are considerably lower than they are in
developed markets, and combined with higher economic growth rates, emerging markets are very
likely to outperform over the next decade.
This low valuation/high growth dynamic should also provide a decent cushion against any downside
volatility, or worse, a crash in global share prices. Interestingly, there is even a proven strategy
available today which converts this volatility into an advantage for investors. That strategy is
described in the last section of this paper.
How Large are Emerging Markets?

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If we are to arrive at some reasonable judgment regarding the appropriate exposure of an investment
portfolio to emerging markets, it is important to understand their size and importance to the world
economy. The table below presents the total market capitalization of the various regions of the world.
Note that the United States represents only 36.2 percent of the worlds market capitalization.
Emerging markets represent 24.6 percent. Thus, if an investor wishes to hold a global portfolio
weighted by market capitalization, almost one quarter of that portfolio would consist of emerging
market equities.

Another metric that might be used to judge the appropriateness of an emerging markets equity
allocation is to examine their share of world GDP. Inter-country comparisons can be tricky, requiring
exchange rate and purchasing power parity adjustments. In one estimate made by the International
Monetary Fund, emerging markets have already exceeded the GDP of the developed market
countries as is shown in Figure 1 below.

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According to the World Bank, by 2020 both China and India will have GDPs exceeding that of the
United States.

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The World Bank reduced its growth forecasts for the global economy in its January 2015 report
summarized in Figure 3. But it noted increasingly divergent trends. The Bank remains pessimistic
about the prospect for the developed world but more optimistic about the emerging economies.
While growth has slowed in the developing world, the growth prospects for emerging-market
economies remain substantially higher than those for the more mature economies. A major reason
for the divergence is the substantial differences in demographies.

Populations are aging rapidly throughout the developed world. The ratio of the working-age to nonworking age population will fall sharply over the next decades as is shown in Figure 4. By the end of
this century, Japan will have more non-workers than workers. On the other hand, populations in
India and Brazil will be getting younger. Even in China, with its one-child policy, the demography will

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remain far more favorable than it is in more developed economies, for at least the next decade.
Countries with younger populations tend to grow faster.

The Different Metrics of Size and Home Country Bias

While there is no single measure of the size of emerging markets to guide an appropriate weighting
in globally diversified portfolios, the discussion above suggests a range of possible parameters.
Emerging markets represent about 24 percent of the worlds equity market capitalization. Floatadjusted, the number is closer to 17 percent. With respect to economic activity, a weight of about
one-half would appear appropriate, where the economic outputs of various countries are adjusted for
purchasing power parity. Emerging markets, with their younger populations, are forecast to grow
more rapidly in the future suggesting that the relative size of these markets will increase as well.
Moreover, more firms are likely to be privatized as economic reforms are implemented in these
countries. Thus, their share of global capitalization should grow as well.
Despite all this, investors in the United States hold a far smaller share of EM equities than would be
consistent with this data. Individual investors hold less than 5 percent of their equity mutual funds in
funds specializing in EM. Institutional investors tend to hold more, but the typical allocation is
generally less than 10 percent. The home country bias appears to be very strong indeed.
Other Portfolio Considerations
When considering the inclusion of an asset class in an investment portfolio, two other factors need
to be considered. Risk and return are essential considerations in building optimal portfolios.
As mentioned earlier, investing in emerging-market equities does involve additional risk. Their equity
markets are extremely volatile and some nations have relatively unstable governments. There are
also currency risks to consider (or the need to engage in potentially expensive currency hedging).
Risk mitigation would indicate a smaller share of ones investment portfolio should be devoted to
emerging markets than the previous discussion might suggest.
Of course, portfolio considerations can cut the other way. As long as the correlations with EM
equities are moderate, adding volatile EM equities to a globally diversified portfolio can actually
decrease portfolio risk.

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Return considerations would justify that a significant share of an investment portfolio should be
devoted to emerging markets. The U.S. equity markets have rallied sharply since the depth of the
financial crisis in 2008, and present valuation levels suggest that future return will be far more
One of the best predictors of long-run equity returns is the so-called CAPE ratio the current price
of the broad U.S. stock-market index divided by the average earnings of the component companies
over the past ten years.* This cyclically-adjusted P/E ratio, or CAPE, is not a reliable predictor of
returns one or two years in the future, but it does provide a useful (though not perfect) forecast of
returns ten years in the future. Figure 5 presents the U.S. data starting in 1926. When stocks had
CAPEs of 10 or less, the U.S. market produced 10-year returns of over 16 percent. But when
CAPEs were over 25, returns tended to be far more modest, averaging under 4 percent.

Unfortunately, the CAPE ratio in the U.S. markets today is over 27 an unusually high reading. Only
in 1929, before the stock market crash and the Great Depression, and in early 2000, at the height of
the Internet Bubble, was the CAPE at higher levels. Figure 6 presents a chart of the historical CAPE
time series. To be sure, interest rates today are unusually low and that provides a justification for
high asset prices. But they have been low in the past, and the data still suggests that we should be
projecting only modest future equity returns.

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The CAPE is a useful indicator for future stock-market returns not only in the United States, but also
in foreign and emerging markets in general. The correlation of the CAPE with future stock market
returns is low for short investment horizons but rises to 0.6 over ten or more years in the U.S. Figure
7 presents some recent data for the CAPE in emerging markets.
Unlike the situation in the U.S., emerging markets have been relatively unpopular and valuations are
extremely modest. Figure 8 shows that EM CAPEs are between 10 and 15. They have been far
higher in the past. At todays levels, they suggest relatively attractive returns over the longer run. The
relative valuations in world financial markets suggest that a substantial allocation to emerging-market
equities can be justified, despite their greater risk.

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Accessing Emerging Market Equities

Investment professionals often argue that if one is to invest in relatively inefficient emerging market
equities, they should look to concentrated, active managers, otherwise known as good stock
pickers. The evidence does not support such a claim.
Figure 9 shows that active management has performed poorly in emerging markets. Those that
outperform in one period are usually not the same as those in the next period. The very inefficiency
of the trading markets in these countries makes active trading from one security to another, as well
as purchasing large blocks of individual stocks, particularly unrewarding. Bid-asked spreads tend to
be high; the same for market-impact costs when big blocks are traded. Moreover, a variety of trading
costs such as stamp taxes makes trading extremely expensive.
Lastly, country weightings drive a great deal of performance differences among strategies, and

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concentrated managers too often get it wrong in their focused pursuit of the best prospective
equities. I strongly believe that diversified, low turnover strategies are the best way to gain exposure
to future growth in emerging markets. After all, if we accept that these markets are poised to do well
over time, additional risks such as portfolio concentration are unnecessary and likely harmful.

Summing Up
Emerging markets represent a substantial share of the total capitalization of world equity markets.
While risky, these stock markets have relatively attractive valuations. A weight of at least 10 to 15
percent of a portfolio in emerging market equities is appropriate for investors who are able to tolerate
some risk, and who have long enough investment horizons to ride out the inevitable ups and downs.
While such an allocation is higher than that recommended by many investment advisors, I believe
that a home country bias has led to their underrepresentation in most globally diversified investment
Is There a Way to Reduce the Risk of EM Investing?
As noted above, investing in emerging markets is risky. One method of measuring that risk is the
increased volatility of EM equities compared with the U.S. market. The best known equity volatility
measure in the U.S. is the VIX index. The VIX is measured by calculating the implicit volatility of
option prices on the Standard & Poors 500 Index. A similar measure of volatility in emerging

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markets can be calculated from the traded options in these markets. VXEEM is the implicit volatility
of emerging markets as calculated from EEM options (representing the MSCI Emerging Markets
Index). CHIX is the implicit volatility of the Chinese market, as calculated from both the FXI ETF and
Hang Seng Index options (FXI representing the FTSE China 50 index; Hang Seng is the benchmark
for Hong Kong-traded securities). Figure 10 shows that the volatility of the Chinese and broader
emerging market indexes are substantially higher than is the case for the United States.

As mentioned above, there is a method of making this increased volatility work in your favor.
Because more volatility means higher options premiums, a strategy of selling index call options
against a long portfolio is particularly useful in emerging markets. The strategy has worked well in
the United States over long time periods, producing essentially market returns with a one-third
reduction in volatility. It is even more effective in more volatile markets because of the more
generous premiums. In effect, this buy-write strategy sells insurance in a risky market which pays
very well for this protection (whether it is upside or downside protection i.e. calls or puts).
Figure 11 presents a payoff diagram showing the results of a covered-call strategy under different
market conditions. We assume a starting price of $100 and the sale of call options with a strike price
of $100 (at-the-money) for $5 per share. The red line represents the different outcomes for a
straight long position. The green line represents the covered strategy (long the stock and short the
option). Note that the covered strategy outperforms the long-only one roughly two thirds of the time.
The covered strategy underperforms only when the price of the stock appreciates by more than the
option premium. The volatility of the strategy is about one-third less than the volatility of the long-only

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Both Emerging Markets and China strategies have been executed with actual funds by the
investment firm WaveFront Capital Management. Results for the China strategy since its inception
(04/2009) have been quite good despite the market haven risen a lot since 2009, which is not an
ideal environment for a hedged strategy to outperform a long-only benchmark. The strategy has
also been executed in emerging markets for a shorter period of time, but the results are comparable.
A covered call strategy removes some of the emerging markets risk, yet preserves investors ability
to earn the returns produced by these stock markets. Option writing also enhances the diversification
benefits of emerging markets securities since writing an at-the-money call option adds a negatively
correlated (-.50) asset to the portfolio. Lastly, the equity portfolios are highly diversified with low
turnover which, as mentioned earlier, are key ingredients for long term success in these markets.
All rights reserved. This material may not be reproduced or distributed, in whole or in part,
without prior written consent of WaveFront Capital Management, LP.
WaveFront Capital Management

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