Emerging market stocks miss global stock surge

(MoneyWatch) Over the past three years, emerging market stocks have turned in just a 0.85 percent annual return. Compare that to the rest of the world where annualized gains for Pacific Rim stocks were 7.91 percent, for European stocks were 10.29%, and for U.S. stocks were 18.01 percent. As the chart of other periods indicates, Emerging Markets came in dead last except in the five-year period, where it eked out a second to last position.

Three years ago, it seemed a sure bet that the US, Europe, and Japan were mounting up debt while emerging market countries were humming along. What happened?

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Jason Zweig noted years ago in Money Magazine and The Wall Street Journal that faster growing economies tend to offer lower stocks returns. He pointed to a study by Elroy Demson of the London Business School that countries with the fastest economic growth have averaged a six percent annual return which is half that of the 12 percent annual return from slower growing economies.

The reason is simple -- everyone knows that countries such as India, China, and Brazil have faster growing economies than Europe, Japan, or the US and that knowledge is priced into their stocks, very much like growth stocks such as Google and Facebook.

So India, China, and Brazil are growth countries while Europe, Japan, and the US are value countries. And research shows that value typically outperforms growth in the long-run. In 2012, Europe was the best performing region with Greece as the best performing country. Value investing worked quite well.

I offer a second hypothesis for emerging market underperformance: There is more corruption in those countries and less of the economic gain flows to shareholders.

To make matters worse, investor returns in emerging market funds tend to badly lag the fund returns as money flows into these funds after stellar performance.

My advice is to own the world but not to overweight emerging markets. A low cost total international stock index fund such as Vanguard's Total International fund (VTIAX) does just that with a low 0.16% expense ratio.