Emerging Markets: Can They Lower Volatility?

(MoneyWatch)  As we saw yesterday, adding an allocation to emerging markets can increase expected returns and portfolio efficiency. However, there's another, and often overlooked, way in which you could benefit from the high expected returns of emerging markets and their low correlation.

Given their higher expected returns, you could include a small allocation (the same 4 percent used in yesterday's example) to emerging markets while lowering the equity allocation by the same amount. Let's see how that strategy would have played out over the period 1988-2009. We again examine two portfolios.

Portfolio A

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

Portfolio B

• 26% S&P 500 Index
• 26% MSCI EAFE Index
• 4% MSCI Emerging Markets Index
• 44% Five-Year Treasuries

	Annualized Return (%)	Annual Standard Deviation	Sharpe Ratio
Portfolio A	8.1	10.9	0.41
Portfolio B	8.5	10.5	0.46

Now we see that the combination of the low correlation and the higher returns of emerging markets with a lower overall equity allocation were more than sufficient to offset the higher volatility of emerging markets. The portfolio produced a higher return with less volatility, and the result was a higher Sharpe ratio.

One of the benefits of adding asset classes with both high expected returns and low correlation is their addition allows you to lower the overall equity allocation, reducing the potential dispersion of returns and the portfolio's volatility.

The Lesson From 2008 2008 was a year in which diversification "failed," as risky assets fell in value and their correlations rose toward one. Unfortunately, many investors took the wrong lesson from that experience - "diversification no longer works."

However, you should recognize that years such as 2008 will likely happen, unpredictably. It's important to understand that the correlations of risky assets will rise from time to time (lowering the overall benefits of diversification) and, perhaps more importantly, that the reduction is both temporary and small.

Summary It appears that many investors have bought into the conventional wisdom that investing in fast-growing economies will generate superior equity returns. However, as we have seen, that strategy has failed to deliver superior performance. Therefore, you shouldn't consider adding an allocation to emerging markets just because emerging markets countries may grow faster than the developed ones. Instead, consider adding them if you are willing and able to take the incremental risks of investing in emerging markets (in exchange for higher expected returns) and to diversify economic and political risks.

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?