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Emerging markets have investors panicking

(MoneyWatch) Whenever an asset class is performing relatively poorly, questions pour in from investors. So it's no surprise that I've been getting lots of calls and emails about the year-to-date performance of emerging markets. The calls have been fueled by articles in the financial press that proclaim warnings like "the investment narrative for emerging markets has shifted, markedly and rapidly. Having been viewed until recently as a promising destination for investors, the asset class is now experiencing significant outflows. And, having been previously characterized as reliable engines of global economic growth, emerging economies are now seen as more volatile and as contributing less to corporate earnings and profitability."

As of August 22, 2013, Vanguard's 500 Index Fund (VFINX) was up 19.5 percent while their Emerging Markets Fund (VEIEX) was down 10.0 percent, a difference of almost 30 percent. That kind of gap often leads to bad behavior as most investors are notorious "return chasers" -- buying what has done well in the past (at high prices) and selling what has been doing poorly (at low prices). Buying high and selling low is not a good strategy, and it's why the evidence shows that investors tend to underperform the very mutual funds in which they invest -- what my colleague Carl Richards calls The Behavior Gap.

This time has been no different, with the financial media reporting on large outflows by both individual and institutional investors from emerging market stock funds and bond funds alike. To help prevent you from engaging in bad behavior, I thought it would be helpful to go over a few key points.

1) Different is better

The first is that in a world where there are no clear crystal balls, just uncertainty, diversification across asset classes is the only prudent strategy. With that in mind, we want a portfolio to be filled with assets that don't have very high correlations, and the lower the better. That means we actually want to see periods when assets are performing very differently. Thus, the fact that so far this year, the U.S. and developed markets have done well while emerging markets have done poorly should be viewed as a good, not a bad, thing. Believing otherwise is making the mistake I call: confusing strategy with outcome -- the strategy of diversification is either right or wrong before we know the outcome.

2) Things will get volatile

Second, emerging markets are highly volatile, and they tend to experience sharp sell offs that typically result from capital outflows. This time around has been no different as capital outflows were spurred by fears that the expected tapering of the Federal Reserve's easy monetary policy would negatively impact their economies. That's part of the risk of investing in emerging markets. And the greater risks are also why emerging markets have higher expected returns. Thus, volatility and periods of poor returns should be anticipated and built into plans, not lead to panicked selling after the prices have already fallen.

3) Take the good with the bad

Third, just as there will be unpredictable periods of poor relative performance, there will also be unpredictable periods of relatively good performance. For example, in 2003, VEIEX outperformed VFINX by 29 percent. In 2004, it outperformed by more than 15 percent. In 2005, it outperformed by more than 27 percent. In 2006, it outperformed by about 14 percent. In 2007, it outperformed by over 33 percent. And in 2009, it outperformed by almost 50 percent! On the other side of the coin, in 2008 when VEIEX lost almost 53 percent, VFINX lost "only" 37 percent, and in 2011 when VEIEX lost almost 19 percent, VFINX gained about 2 percent. As we said, this type of dispersion in returns is a good thing, as long as you can recognize and accept the fact that neither you nor anyone else can forecast them ahead of time.

4) Don't just dump

Fourth, investors dumping their emerging market holdings are probably unaware that they're doing so (as they typically do) at a time when they have much lower valuation metrics. For example, Morningstar shows that as of March 2013, the forward-looking price-to-earnings ratio for VFINX was 14.3, while it was just 11.8 for VEIEX. And VFINX price-to-book market ratio was also much higher than VEIEX's at 2.0 compared to 1.6. Dimensional Fund Advisors (DFA), which runs passively managed asset class funds, provides us with data that's more current, with valuations as of July 31. DFA's Large Company fund (DFUSX) has a P/E ratio of 15.5, compared to just 12.4 for its emerging markets fund (DFEMX). Similarly, DFUSX has a price-to-book ratio of about 2.2, compared to just 1.5 for DFEMX. These significantly lower valuation metrics translate into higher expected returns. [Disclosure: My firm uses DFA in building client portfolios.]

5) The holy grail

The bottom line is that whether we are talking about emerging markets or small-cap value stocks, you must accept that along with the higher expected returns comes increased volatility and lots of what is referred to as tracking error -- your portfolio's returns won't mirror the "market's" return. Thus, the key to getting the higher expected returns is sticking through periods when performance is ugly. Even better would be to rebalance the portfolio on regular basis, as your investment policy statement should require. By adhering to your plan, you would be selling at relatively high prices (when expected returns are lower) and buying at relatively low prices (when expected returns are higher) -- the "holy grail" of investing.

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