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Rekenthaler Report

Rethinking International-Stock Asset Allocation

When emerging-markets stocks lose their spot.

Bad Timing?
Several readers of Friday’s column responded that emerging-markets shares haven’t lagged solely because their companies have disappointed. They also have been discounted. Whereas emerging-markets equities once commanded relatively high price/earnings multiples, they now sell for less than developed-markets stocks--particularly those of the United States.

Meaning that the article might have been a contrarian signal. When an asset performs so poorly that even Rekenthaler notices, that could be because the investment has rock-bottom, with nowhere to go but up.

There’s something to that idea, although it is far from foolproof. For example, contradicting this column’s implied advice by buying managed-futures funds in 2013, or swapping growth for value stocks in 2015, would have been unhelpful. But it’s true that historical performance analysis runs the danger of being ill-timed. Some of the best buys are assets that indisputably were worthless.

(And emerging-markets stocks have indeed been useless. A reader tested 11 different asset allocations over the 31-year period from 1988 through 2019, for the two-investment portfolio of 1) MSCI USA Index and 2) MSCI Emerging Markets Index. The 100% USA allocation scored the highest Sharpe ratio. Each dollop of emerging-markets stocks reduced the ratio, with the worst result being for 100% emerging markets.)

Color me neutral. Sometimes, I criticize investments because they will not earn their keep. This is not one of those occasions. Emerging-markets equities have major drawbacks, but they also enjoy genuine business opportunities. In that, they do not resemble market-neutral funds, which carry an expected return of Treasury bills minus expenses--meaning, pretty much nothing. Over time, emerging-markets equities should record significantly positive returns.

Asset-Allocation Models
I just don’t think that is enough to justify being their own asset class. There are 136 Morningstar Categories (including exchange-traded funds). Of those 136 categories, only two boast their own asset-allocation slots: high-yield bonds and emerging-markets equities. Otherwise, either several fund categories are funneled into a single asset-allocation slot (as with large-company U.S. stocks), or a fund category has no slot at all (convertible bonds).

Both those privileges should be revoked.

High-yield bonds behave like a blend of value-style U.S. stocks and intermediate-term bonds. Over the trailing three years, you could have formed a portfolio made up of 50% large-value stock funds and 50% intermediate-term bond funds and made 6.5% annually, or you could have placed them all into high-yield bond funds and made 6.5% annually. Two paths leading to the same place. High-yield bond funds are perfectly acceptable, but they don’t belong in asset-allocation schemes when can readily be duplicated by using basic asset classes.

The argument is different for emerging-markets stocks. In their defense, one cannot get similar investment results by combining other assets. Emerging-markets stocks do provide something special. However, while possessing unique performance is a necessary condition for an asset class, it is not sufficient. There must also be an internal logic--an economic reason to justify occupying the spot.

Faulty Logic
I don’t see it. Consider India. It is true that the Indian economy is not fully correlated with other countries’, that the Indian currency moves on its own, and that many Indian companies operate predominantly within their home country. All these things give Indian stocks their own rhythm. But being different is not enough. Indian equities are but a tiny fraction of the global equity markets. For U.S. investors--the Indian investor’s needs are different--the Indian stock market is too small to warrant the attention.

The emerging markets overall are larger, so that emerging-markets stocks account for 5% of the global financial-assets market. (They account for 20% of non-U.S. stock assets, which in turn make up about half the global stock market--the U.S., of course, possessing the other half. That cuts their weighting to 10%, which is halved again when fixed-income investments are considered.) That might be enough for an asset class.

However, when bundling the various emerging-markets countries into a single package, the performance characteristics become blurred. India moves, to an extent, on its own cycle; as does China; as does Russia; as does Brazil. Place them together, though, and their aggregate returns start to resemble the rest of the world’s. The packaging mutes the national idiosyncrasies. The result is something that, increasingly, resembles the rest of the world stock market, only with somewhat greater volatility.

Planning Ahead
For U.S. investors, the existing asset-allocation framework contains three geographic tiers: 1) domestic, 2) foreign developed markets, and 3) emerging markets. I do not propose, today, to overhaul the current scheme. That would be a step too far. Rather, I suggest modifying it, by folding the third group into the second. Two asset buckets for non-U.S. equities is plenty. No need to complicate one’s investment life by using a third slot, which likely will occupy only a sliver of the portfolio.

Over time, though, the entire scheme should be overhauled. What matters in today’s globally connected marketplace (wherein every country’s ruling political party claims to control the economic winds--at least, as long as those breezes blow favorably--while being almost completely unable to do so) is not where the corporations are headquartered but instead where they conduct their businesses and how they are affected by currency movements.

Ultimately, I believe, asset-allocation models will emphasize those attributes. They will create equity portfolios of companies that have geographically diverse revenue streams, with the aggregate currency exposures noted, and adjusted as necessary. Just as now, some investors will favor growth-oriented strategies, while others will prefer value stocks. The latter will likely hold more emerging-markets stocks than the former--but as a corollary of their asset-allocation choices, not as the direct effect.

Mail It!
A few weeks back, Morningstar disabled the Comments section for its individual articles, including this column. The powers-that-be prefer that reader exchanges occur in the Discuss forums. As my wife likes to say, “Not my circus, not my monkeys.” Their call; not mine. However, I will note that I enjoy receiving emails. I read them all and respond to most. (If I fail to respond, it is not a comment on the email's quality but rather that I was absent-minded and buried the note.)

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.