By MoneyMorning.com.au
Emerging markets have had a great year so far. The MSCI Asia ex-Japan index is up since the start of 2012, as is the wider MSCI Emerging Markets benchmark.
Western markets are mostly up by less than half as much. But of course, this comes off the back of an exceptionally poor year for emerging market stocks. Had you been in US equities throughout 2011, you’re still some way ahead.
As usual, there are plenty of explanations for why this is happening. Stronger US growth will boost exports. China is set to loosen its property sector curbs. Greece will avoid default and get its next bail-out.
But the reality is something a bit more tangible than that…
Returns on Emerging Markets Depend on Foreign Money
Emerging markets generally don’t have a large domestic investor base. In particular, they don’t have many institutions such as pension funds and insurers that tend to be steady buyers of stocks.
As a result, buying and selling by foreign investors has a major impact on the direction of most emerging markets. Flows in and out of the country drive a large proportion of short-term performance.
So far this year, emerging market equity funds have pulled in $19bn. That’s about half the money that flowed out last year, according to funds tracker EPFR.
You see this a lot in emerging markets. In 2008, $39bn fled the region. In 2009, $64bn piled back in. Obviously, swings this size by foreign investors trump local sentiment.
Why are foreign investors buying back in now? It’s not about the fundamentals. Very little has changed between late last year and early this year – certainly not enough to justify a completely different assessment of the risks and rewards of emerging markets.
The truth is that people are investing again because emerging markets are going up – it’s that simple. And emerging markets are going up because they’ve attracted foreign money – which in turn attracts more foreign money and so on, in a virtuous circle.
It’s just crowd behaviour. And I am in no doubt that sooner or later it will reverse, and investors will blindly dump their holdings once again.
In due course, many emerging markets will build up their financial infrastructure. With a larger core of domestic buyers, this tendency to dance to the tune of foreign buyers will decrease. But in most cases, that’s still a good way away.
Good Asset Allocation Can Deliver Excellent Returns
Dealing with this kind of volatility can be difficult – which is why many investors lose money in emerging markets. They buy and sell in line with flows, ensuring they come in and out of the markets at the wrong times.
So what’s the solution? One answer is almost to ignore it. Buy decent companies in good markets that you believe will outperform over time. As long as they do not become clearly overvalued, you ignore what happens month-to-month. In this way, you aim to pick up a premium for holding your nerve and being very patient.
This is the style of investing I prefer – but I admit it’s not exciting. The alternative is to try to design your strategy to capitalise on these moves. For most portfolios, your allocation between different assets is more important in determining your eventual returns than your choice of individual stocks. And the huge swings we see in emerging markets mean that if you get your asset allocation calls right, you can deliver some pretty good returns.
Cris Sholto Heaton
Contributing Editor, MoneyWeek (UK)
Publisher’s Note: This is an edited version of an article that originally appeared in MoneyWeek (UK)
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