Increasing Your Emerging Market Asset Allocation
International and emerging market stocks have underperformed US stocks for years and are now very underpriced comparatively. Now is a time for investors to consider increasing the allocation of foreign and emerging market stocks in their portfolios.
Recent Performance History
Emerging markets have underperformed US stocks significantly over the past few years. An investment of $100 on December 31, 2009 in US stocks was worth $207 on December 31, 2015. The same $100 investment in emerging market stocks was only worth $92 on December 31, 2015.
US stocks have more than doubled and emerging market stocks have lost money over this time period.
What are Emerging Markets?
China, Taiwan, India, South Africa and Brazil account for over 70% of the Vanguard emerging market stock fund.
2.9 billion people live in either China, Taiwan, India, South Africa or Brazil. There are about 7 billion people in the world and these 5 countries alone account for 41% of the world population.
Emerging Market Valuations
The following infographic shows the China, India, Brazil and Russia stock market valuations to be in the bottom half of the world.
The emerging markets cyclically adjusted price to earnings ratio divided by the US cyclically adjusted price to earnings ratio is near the all time lows of the 1997 Asian Financial Crisis.
Emerging market stocks are really cheap right now.
Emerging Markets Allocations of Famous Investors
In June 2015, Jeremy Siegel “recommended investors allocate 50 percent of their portfolios to the U.S., 25 percent to non-U.S. developed markets, and 25 percent to emerging markets.” Siegel’s recommended allocation overweights emerging markets and underweights non-U.S. developed markets compared to a global market capitalization index.
The Vanguard Total World Stock Index Fund is 56.1% U.S., 35.1% non-U.S. developed (Europe and Pacific) and 8.8% emerging markets. The Vanguard Total World Stock Index Fund tracks the “FTSE Global All Cap Index, a float-adjusted, market-capitalization-weighted index designed to measure the market performance of large-, mid-, and small-capitalization stocks of companies located around the world.”
Burton Malkiel recommended an asset allocation of 25% U.S., 25% non-U.S. developed, and 50% U.S. in 2011:
Research Affiliates is an indexing and asset allocation firm founded by Rob Arnott. Research Affiliates is optimistic about emerging market funds and they manage the two funds with allocations of 35% and 39% to emerging markets.
Mebane Faber notes that US stocks are expensive, foreign developed stocks are cheaper, and emerging markets are even cheaper. “The cheapest countries are the cheapest they’ve ever been.”
Jack Bogle, the founder of Vanguard, puts 50% of his money in U.S. stocks and the other 50% in a U.S. bond index fund. Bogle doesn’t think that any assets should be invested in non-U.S. developed or emerging markets. Barry Ritholtz and Cullen Roche don’t agree with Bogle’s home-country bias.
The experts are telling us to invest anywhere from 0% to 40% in emerging markets — that is quite the spread. What should we do?
My bold prediction
Emerging markets were extremely popular from 2004–2007 and are not extremely unpopular. I think it is best to buy investments that are unpopular and sell investments that are popular. I agree with Mebane Faber and Research Affiliates that emerging markets will return more than U.S. stocks in the coming years.
Financial pundits love making vague predictions like “emerging market stocks will outperform”, so they can claim they were right if emerging market stocks do well and twist the meaning of their words if they were wrong. I am going to make a quantifiable prediction that cannot be manipulated later.
The following portfolio, rebalanced annually, will outperform the Vanguard Total World Stock Index Fund from January 1, 2016 until December 31, 2017.
- 40% Vanguard Emerging Markets Index Fund
- 35% Vanguard S&P 500 Index Fund
- 25% Vanguard Total International Stock Fund (a portion of this is emerging markets)
The performance will be measured on an absolute basis, not a risk adjusted basis. This prediction is being made on May 4, 2016. I will use the Portfolio Visualizer backtesting tool to measure the accuracy of my prediction.
Rebalance at your own risk :)