Andrew Hallam is the index investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.
My morning routine is much like yours … with one subtle difference. I get out of bed. Shower. Get dressed. Eat breakfast. And brush my teeth with bottled water. Yeah, bottled water.
I don't bother with tap water because I'm currently travelling in Vietnam. Unpleasant parasites live in emerging market water. Last month I was in China. Next month I'll be in Thailand. Diarrhea-causing devils swim in all three zones.
Parasites (from a foreign investor's perspective) also exist in emerging market stocks. It's one of the reasons I don't own an emerging market index. Risk and return are supposed to be proportional. When you take higher risks, you can expect better returns. For example, stocks are riskier than bonds. But over time, stocks beat bonds. So investors get rewarded for taking extra risk. The same rule is supposed to apply to emerging market stocks. They're riskier than developed market equities. So they should earn better returns. The problem is, they don't.
Strategy Lab readers, I can hear what you're thinking: Hallam is a hypocrite. Guilty as charged. When I built my Strategy Lab model portfolio, I did add a dash of an emerging market index. Doing so gave exposure to the entire global market.
Let me explain, however, why I don't personally drink the emerging market Kool-Aid. I realize their GDP growth runs circles around those of developed markets. But shadier legal frameworks and poor corporate governance cause their stock markets to lag. According to a 2014 BlackRock study, they capture only 73 per cent of their countries' GDP growth. For example, if GDP grew by 8 per cent per year, stock market growth would be roughly 5.8 per cent. Such markets promise the world. But they rarely deliver.
Chinese stocks make up a large part of the emerging market index. But they perform like a drunken rock climber. They climb. They fall. They climb again. They fall. Few people realize how poorly they perform.
The Chinese stock market opened to foreigners in 1993. The country's GDP has soared. But its stocks haven't. If $10,000 (U.S.) were invested in Chinese stocks, it would have grown to only $15,343 after 22 years. That's an average return of just 2 per cent a year.
In contrast, over the same 22-year period, $10,000 in U.S. stocks would have grown to $71,570. That's an average of 9.4 per cent a year. In Canadian stocks, $10,000 (Canadian) would have grown to $73,639 for a 9.5 per cent annual return.
Chinese stock exposure, however, isn't the only reason I avoid emerging market funds. In David Swensen's book, Pioneering Portfolio Management, the university endowment fund manager says, "A particularly prevalent problem in many Asian countries involves family-controlled companies satisfying family desires at the expense of external minority shareholder wishes." He says this is one of the reasons emerging market stocks haven't kept pace with developed markets.
Numbers from the World Bank's International Finance Corporation reveal that $100,000 invested in a broad, random selection of emerging market stocks in 1985 (the earliest date from which we have emerging market data) would have grown to $1.1-million by 2006. If it were invested in U.S. stocks, it would have grown to more than $1.3-million. And if invested in developed world stock markets (excluding the United States), it would have grown to $1.2-million.
During the past five years, to Feb. 10, the iShares MSCI Emerging Markets ETF (XEM) has gained a total of 33.4 per cent (measured in Canadian dollars). In contrast, Canada's iShares Core S&P/TSX Composite Index (XIC) is up 47.9 per cent. The U.S. market, as measured by the iShares Core S&P 500 Index ETF (XSP) is up 105.4 per cent. Developed world markets (excluding the U.S.) can be measured by the iShares MSCI EAFE Index ETF (XIN). It's up 55.8 per cent over the past five years.
Stocks from China and other emerging markets won't always drag their feet. Sometimes they'll soar. But corruption and deception cause parasitic leaks. So I keep my money in a Canadian stock index, a U.S. stock index, a developed world international index and a Canadian bond index.
That's something I can drink to.
Andrew Hallam