By Brendan Conway

Emerging markets get a nod this weekend from fundamental indexing guru and Research Affiliates  CEO Rob Arnott for being  in the sweet spot of long-term demographic change and short-term valuation. The comments come in colleague Lawrence C. Strauss interview with   Arnott in the print edition of Barrons:

Whats your assessment of emerging markets?

Fear creates bargains. When we buy something as contrarians, our clients routinely say, Why are you buying this; dont you see whats going on? Our reply is, Well, yes. Thats why these markets got cheap. Two years ago, our allocation to emerging markets was really skinny. Today, it is much, much greater because people are afraid.

Natalie Brasington For anyone with a time horizon longer than one or two years, emerging markets look to be in the sweet spot. Rob Arnott

We are going to go through a period with an abnormal number of senior citizens, and that will create large support ratios, in which nonworking people far outnumber working people, particularly in Japan, elsewhere in East Asia, and parts of Europe.  That challenge will be a little daunting for the politicians. The politics of the next 20 years is going to make the politics of the past 20 years look polite and serene. But 30 to 40 years from now, we are going to be looking at a transition to a new steady state in which births equal deaths. But to get there, the birthrate must revive to replacement levels, and thats going to be interesting to see how that transpires because we need to get fertility rates up.

What kind of birthrate is necessary?

An average of 2.1 children per woman. In the developed world,the rate now it is well below two. In the U.S. it is nearly two, so we are OK [with the help of immigrants]. In Western Europe, its in the high ones. In East Asia—South Korea, Japan, Hong Kong, and Singapore—the birthrate per woman is way below two. In some of these countries, its as low as 1.2 or 1.3. In an extreme context, lets suppose that, on average, every woman has one child. Eventually, the population drops by 50% every generation, and the support ratios are truly horrific. So that cant work long term, but this is not a problem for today. This is, quite bluntly, not a problem for our generation, but we can point it out to our kids and grandkids and say, Hey, this is something for you to think about.

What are these trends investment implications?

Over the next three to five years, valuations begin to be dominant, and that points to emerging markets. And over the long term, demography plays a huge role, and that also points to emerging markets. For anyone with a time horizon longer than one or two years, emerging markets look to be in the sweet spot.

Checking in on the groups year-to-date performance, iShares MSCI Emerging Markets ETF  (EEM ) is ahead by just under 1%, or within shooting distance of the S&P 500. Thats after starting the year with an 8.6% loss in January, then gaining 3.4% in February and 3.8% in March.

Vanguard FTSE Emerging Markets ETF (VWO ) is ahead by 1.5% during 2014. The three-times leveraged Direxion Daily Emerging Markets Bull 3X Shares (EDC ) is down 2.3%. The leveraged ETF began the year by slumping 25% in January.

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