Emerging Markets: How the Asset Class Affects a Portfolio

(MoneyWatch)  We've been looking at some things to consider when investing in emerging markets. But as we have discussed many times, you shouldn't consider investments in isolation. Instead, you should consider how their addition impacts the risk and return of the entire portfolio. Consider the following.

The high volatility of individual emerging markets shouldn't matter, as long as you hold a diversified portfolio of emerging markets. And the volatility of emerging markets as a whole shouldn't be of concern either. What does matter is how much an incremental holding in emerging markets contributes to the risk of their overall portfolio. Thus, we consider two portfolios, A and B, each with a 60/40 equity-to-fixed-income allocation.

Portfolio A

• 30% S&P 500 Index
• 30% MSCI EAFE Index
• 40% Five-Year Treasuries

Portfolio B

• 28% S&P 500 Index
• 28% MSCI EAFE Index
• 4% MSCI Emerging Markets Index
• 40% Five-Year Treasuries

The period is 1988-2009, and portfolios are rebalanced annually. During this period the S&P 500 returned 9.6 percent, the MSCI EAFE returned 5.7 percent and the MSCI Emerging Markets returned 13.8 percent.

	Annualized Return (%)	Annual Standard Deviation	Sharpe Ratio
Portfolio A	8.1	10.9	0.41
Portfolio B	8.5	11.2	0.44

As you can see, the addition of a small allocation of emerging markets produced a more efficient portfolio. Portfolio B benefited from not only the higher returns of emerging markets during this period, but also from the non-perfect correlation of emerging markets with developed markets. Their annual correlation with the S&P 500 was 0.52 and with the EAFE it was 0.74.

It's important to point out that the relatively low correlation of emerging markets to the other portfolio assets was not sufficient to offset their much higher volatility. Thus, Portfolio B exhibited greater volatility than Portfolio A. Tomorrow, we'll see another way you can benefit from the high expected returns of emerging markets and their low correlation.

Follow the series: Emerging Markets

• Part one: The Relationship Between Growth and Returns
• Part two: Why Growth Doesn't Equal Returns
• Part three: How the Asset Class Affects the Portfolio
• Part four: Can They Lower Volatility?