Emerging Markets: When Are They Worth It?

Using 24 years of data, we show that emerging market equities are a worthy addition to a U.S. investor's portfolio of developed market equities. Specifically, portfolio returns increased by approximately 1.5 percentage points a year when emerging country equities were included in the investment set. When we considered U.S. Federal Reserve monetary policy, however, we found that the benefits of investing in emerging markets accrued almost exclusively during periods of restrictive U.S. monetary policy. During periods of expansive U.S. monetary policy, the benefits to a U.S. investor of holding emerging market equities were trivial. An implication of our findings is that evaluating monetary conditions is a necessary prerequisite to identifying an optimal allocation of assets to international equities. The study we report reexamined the benefits to U.S. investors of investing in international equities, with a focus on emerging market stocks and on differences in returns and risks between periods of expansive U.S. monetary policy and periods of restrictive U.S. monetary policy. Several past studies have shown that international equities offer diversification benefits for U.S. investors, primarily because of the relatively low correlation of non-U.S. with U.S. stock returns. Emerging market equities have been shown to have particularly low correlations with the U.S. stock market. A troubling aspect of the past correlation findings, however, is that the correlations of non-U.S. and U.S. equity markets differ substantially over time. Of even more concern is the finding that the correlations tend to increase during periods when the markets are exhibiting the worst performance. Thus, the benefits of international diversification may be lowest when diversification is most needed.Our analysis had two basic objectives: to quantify the overall benefit of investing in emerging markets and to determine whether the benefit fluctuates systematically with changes in U.S. monetary conditions. Based on recent evidence that shows stock market performance in developed countries to be systematically related to broad changes in monetary policy, we hypothesized that the benefits of international diversification may be related to changes in U.S. monetary conditions. In particular, previous findings confirm that, in the developed markets, equities perform much better (worse) than average during expansive (restrictive) monetary periods—perhaps because the monetary authorities in developed countries tend to cooperate in setting monetary policy. We argued, however, that the monetary policy decisions of developing country monetary authorities are less likely to coincide with their counterparts in developed countries. Thus, relative to the developed markets, emerging markets might provide a more effective hedge against the poor performance exhibited by U.S. equities during periods of restrictive U.S. monetary policy.The sample used in this analysis compares favorably with past research, based on both breadth and length of time period covered. We considered returns to 20 emerging markets over a 24-year study period, whereas past studies relied on approximately half as many countries and a much shorter time frame. Therefore, our findings are less influenced by extreme observations that may have occurred in a particular time period or a particular country.Our results indicate that adding emerging market equities to a portfolio that consists of developed country equities adds a net benefit of 1.5-2.0 percentage points (pps) a year to returns. This finding confirms the view that emerging market equities are an attractive diversification vehicle for U.S. investors. Furthermore, we found that emerging market equities represent a significant weight in both high-risk and low-risk efficient portfolios, which indicates that emerging market equities are beneficial even for equity investors with relatively high levels of risk aversion.A more surprising result is that the benefit associated with investing in emerging market equities accrues almost entirely during periods of restrictive U.S. monetary policy; we found the net benefit to be more than 4 pps annually. During periods of expansive U.S. monetary policy, emerging markets added only a trivial improvement to portfolio performance (approximately 0.2 pps a year). This finding indicates that a necessary prerequisite to determining the appropriate allocation to international equities is to monitor U.S. monetary conditions.