One of the key messages of the book Investment Beliefs that Kees Koedijk and I wrote, was the importance to articulate your views on how financial markets work. However much we’d like it to be, investing is not a hard science, and academics bicker over the most fundamental tenets of portfolio management. This shifts the burden to investment managers and trustees who simply have to make choices and formulate their beliefs on how the markets work. In our book, we covered beliefs such as risk premia, investment horizon, sustainability, costs, risk management. This is not a complete list. Markets develop, innovate and shed old ideas. Once you start thinking about beliefs that dominate the investment debate, the list tends to grow.

Professor Amin Rajan, CEO from Create Research, recently reviewed our book in the magazine Investments and Pensions Europe. The review was positive, which delights us of course. But he also added some homework by asking “Should investing in emerging markets not be considered a true investment belief?” Amin Rajan is right on the spot with this question. Yes it is, and the subject definitely merits more attention.

An overview of Emerging Markets

Investors believe that Emerging Markets, due to their high growth (potential) and different phase of economic growth, are good diversifiers to the developed equity markets. Emerging markets are stock markets in countries that have a developing economy. These countries have large and growing populations; populations of people who want to buy goods and services and a decent industrial base to manufacture and sell their goods both to their local population and to global customers. Examples of emerging markets are countries like South Korea, South Africa, India, China, Indonesia and Brazil. Goldman Sachs once coined the term BRIC for the fast lane countries. BRIC stands for Brazil, Russia, India and China. The BRIC companies and stocks markets are well- known now and heavily invested in. The new fast lane is the “New Frontier Markets”, including the countries of Mexico, Egypt, Nigeria, Turkey, Pakistan, Indonesia, Bangladesh, Vietnam, Iran and Philippines, and a score of oil rich Middle Eastern countries.

Why invest in Emerging Markets: facts and myths

Having emerging market stocks in your portfolio help to diversify your stock holdings. The stocks of emerging markets can have wild swings up and down; generally more volatile than regular equities. So investors (should) expect a higher risk premium for emerging markets than for developed markets. Are they right in their assumptions? Consider the following arguments:

1. Emerging markets generally grow much faster than developed Western countries. Ex ante equity risk premiums are usually a combination of real GDP growth, inflation, and repricing of valuation due to investor optimism or pessimism [1]. However, as John Authers argued in the Financial Times on April 16, there is no correlation between GDP growth and stock market returns.

2. Emerging Markets are only temporarily attractive due to the exceptional policy of the Fed. John Authers suggests that in absence of correlation between GDP growth and Emerging market returns, the Quantitative Easing policy of the Federal Reserve, buying bonds to keep the yields low to stimulate economic activity. Investors, on their part, are seeking returns and move money out of the US to Emerging Markets

3. Some analysts argue that investors do no have to move money to Emerging Markets. A better policy instead is to invest in European and US companies that venture into China, India and Indonesia. This results in similar diversification advantages. A bonus is that the information and governance of developed companies are far better than of Chinese ones. On the other hand, we know that foreign investments fail to pay off regularly, and if the companies want to expand too eagerly, they are curtailed (like Unilever and Google in China recently). This certainly will not improve shareholder value.

4. The high returns in emerging stock markets might simply point to other macro-economic imbalances: the combination of an underdeveloped financial system and too much savings. The Chinese stock market is, in terms of market value to GDP, rather tiny compared to US and European markets. Lagging growth in domestic consumption and too few real investment opportunities leads to investing the spare cash in the stock markets, creating stellar returns. Nothing new, as Japanese investors can attest to in the 1980s.

Reviewing these arguments, investing in Emerging Markets is yet another unanswerable investment debate that might be best served by framing it as an investment belief for a structured discussion between trustees and investment managers.

[1] Antti Ilmanen, Expected Returns on Stocks and Bonds, the Journal of Portfolio Management, Winter 2003, Vol. 29, No. 2: pp. 7-2