Why emerging markets underperform

(MoneyWatch) Over the past couple of years, emerging-markets stock performance has badly lagged the U.S. In fact, it has even lagged Europe. The chart below tracks the iShares emerging-markets ETF (EEM) in blue, the iShares Europe (IEV) in red and the iShares US (ITOT) in green.

Source: Yahoo! Finance

During this same period, emerging-markets stocks lost about 12 percent of its value, while their U.S. counterparts were up 30 percent plus dividends.

This current trend is actually a continuation of a very long-term trend: Slower-growing economies slightly outperform faster-growing economies over long periods of time.

Why economic growth leads to lower stock returns

It would seem counterintuitive to think that China, India and Brazil wouldn't outpace the stock returns of the U.S. and Europe. Yet intuition is usually wrong when it comes to investing.  

There are a couple of reasons emerging-market stocks tend to lag. First, it's common knowledge that China, India and Brazil are rapidly growing economies, and their stocks are priced accordingly. These are growth countries, while Europe and the U.S. fall into the value category. And value typically beats growth because the high expectations the market has priced into growth are much harder to achieve than the low expectations priced into value. A perfect example would be Apple (AAPL). Despite the rapid growth it has had over the past year, the stock has been clobbered due to markets' expectations of much more.

Second, emerging-markets countries tend to suffer from more corruption than do the U.S. and Europe, with the result that much of the rapid economic gain isn't captured by shareholders. 

My advice

I do not advocate avoiding emerging markets, but I would avoid the temptation to overweight them. It's best to own the whole world, as I do, by using the Vanguard Total International Fund (VXUS), which allows investors to hold essentially every international company in every country outside the U.S.