Summary

• From 2011-2013, the MSCI Emerging Markets Index about broke even, underperforming the S&P 500. Investors are once again fleeing.
• Emerging equity markets have been more volatile than developed markets. However, volatility has been falling.
• Current valuations suggest that emerging markets will provide higher returns than either the U.S. or other developed markets.

From 2000 through 2010, the MSCI Emerging Markets returned 10.9 percent a year, outperforming the S&P 500 by 10.5 percent a year. In typical fashion, investors flocked to emerging market funds. Since then, returns have been poor, providing negative returns in both 2011 and 2013 (as well as in the first two months of this year). From 2011 through 2013, the MSCI Emerging Markets Index about broke even, underperforming the S&P 500 by a cumulative 57 percent — and investors are once again fleeing.

How should investors think about emerging markets? Elroy Dimson, Paul Marsh, and Mike Staunton, authors of the wonderful book The Triumph of the Optimists: 101 Years of Global Investment Returns, bring their unique perspectives to this question in Credit Suisse’s 2014 Annual Global Yearbook .

While the MSCI Emerging Markets Index only goes back to 1988, they are able to use their extensive long-run returns database to construct an emerging markets index since 1900. To have consistency, they defined a country as an emerging market if the country’s GDP per capita was less than $25,000 in today’s dollars. Using this rule, they constructed a long-run emerging markets index starting in 1900 with seven countries, adding countries as returns became available. And they compared the performance to a similar series for the developed markets, which began 1900 with 16 countries. The following is a brief summary of the historical evidence they present.

From 1900 through 2013, the developed markets returned 8.3 percent per year and outperformed the emerging markets, which returned 7.4 percent per year. While the emerging markets outperformed in the early part of the 20th century, they were hit badly by the Russian revolution, in which investors were wiped out. (And Russia was one of the largest stock markets at the start of the century.) They also underperformed in the 1920s, though they didn’t suffer as much in the Great Depression. They did experience another crash after World War II, with the Japanese market being the biggest contributor, losing almost 98 percent of its value. The collapse of China in 1949 was another big contributor. Then from 1950 to 2013, they achieved an annualized return of 12.5 percent, versus 10.8 percent from developed markets.

Dimson, Marsh, and Staunton, also provided us with insights into other important issues related to the emerging markets. We’ll summarize them.

Volatility

As you would expect, emerging equity markets have been more volatile than developed markets. However, volatility has been falling. At the end of 1980, it was about 40 percent. By 2013, it had fallen to 27 percent. That’s the same volatility as for U.S. small-cap stocks. As these emerging markets developed over time, volatility has been declining, as we would expect.

Correlations

The main reason to consider investing in emerging markets is the diversification benefit. The authors note that correlations between developed and emerging markets have risen as the emerging markets countries have continued to develop. However, the correlations are still well below 1 — meaning there’s still a significant benefit. They also note that the rising correlation has been greatly impacted by the systemic shock that impacted all risky assets in similar ways — the financial crisis of 2008. Since that crisis, correlations have once again fallen. The average correlation of 0.60 between emerging markets and developed markets for a US investor remains low, showing there is still much scope for risk reduction. And they noted that emerging markets offer stronger diversification benefits than other developed markets.

Factor Returns

The three most well-known factors in developed markets are size, value, and momentum. While the data is for a very short time frame, from 2000-2013, the same premiums existed in the emerging markets. The size premium in emerging markets was 1.9 percent, smaller than the premium in developed markets (6.6 percent). On the other hand, the value premium in the emerging markets, at 4.3 percent, was larger than in the developed markets (3.1 percent). There was also a momentum premium in emerging markets (0.24 percent per month), though weaker than in the developed markets (0.7 percent per month).

GDP Growth and Stock Returns

Consistent with their prior research, they found that economic growth is negatively correlated with stock returns. A simple explanation is that buying growth markets fails to outperform because all information about past growth is already impounded in market valuations. Another explanation is that a period of low economic growth for a country, or a period of currency weakness, is simply another proxy for the value effect. Weak growth and weak currency countries are often distressed and higher risk. So investors demand a higher risk premium. And the higher returns reflect that risk premium.

In their concluding remarks, the authors noted that thirty years ago, emerging markets made up just 1% of world equity market capitalization and 18% of GDP. Today, they comprise 13% of the free float investable universe of world equities and 33% of world GDP. They added: These weightings are likely to rise steadily as the developing world continues to grow faster than the developed world, as domestic markets open up further to global investors, and as free float weightings increase. With that in mind, along with the benefits of diversification that emerging markets provide, you should consider 13 percent as a starting point for your allocation to the emerging markets.

I would add that current valuations suggest that emerging markets will provide higher returns than either the U.S. or other developed markets. My recent Seeking Alpha post showed that based on the Shiller CAPE 10, investors should expect the following real returns: U.S. 4.2 percent, EAFE 6.4 percent and Emerging Markets 7.1 percent. Thus, investors who underweight emerging markets are likely sacrificing returns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.