The Continuing Case for Investing in Emerging Markets


KEY TAKEAWAYS
  • Emerging markets make up a meaningful part of global equity markets.

  • Therefore, it makes sense for investors to include emerging markets as part of a globally diversified portfolio.

  • Dimensional’s flexible, systematic approach to investing can help navigate the challenges associated with investing in emerging markets.

It’s no wonder investors are questioning the place of emerging markets in their portfolios: Emerging markets stocks have underperformed US stocks in eight of the last 10 calendar years,1 and Russian stocks plummeted and were pulled from all major indices in the first quarter of 2022.2 

Because markets in developing countries make up a meaningful part of global equity markets, it makes sense for investors to consider including them as part of a globally diversified portfolio. Nevertheless, they do present some unique challenges. A flexible and systematic approach can navigate these challenges. Dimensional has been investing this way for decades and, as a pioneer in systematic investing, has learned to apply flexibility to help weather the inevitable storms.

A Growing Share of the Market

Emerging markets made up 12% of global market capitalization at the end of March 2022, up from just 3% two decades ago (see Exhibit 1). It’s a large share of the market to ignore. Market-cap weights are based on prices, which reflect the aggregate of investors’ expectations of risk and return, so a market-cap-weighted allocation allows your portfolio to adjust in real time to changes in that risk-return tradeoff.

exhibit 1

Gaining Ground

Emerging markets as a share of global markets, January 31, 1990–March 31, 2022

Including emerging markets in your portfolio offers diversification benefits because returns for these markets overall historically have not moved in lockstep with those of developed markets.

Markets in developing countries often have a wide range of returns. Emerging markets may be susceptible to heightened political risk—for example, the impacts of sanctions due to Russia’s invasion of Ukraine or increased regulatory oversight of certain companies in China. It’s no surprise we see varied outcomes in returns across markets.

That was clear during the first quarter of this year, when Peru was up 35% while Russia declined by 100%. Egypt was the second-worst-performing emerging market, declining by 21%. While developed markets see wide dispersion in returns, it is often to a lesser degree. The difference between the best-performing developed market (Australia) and the worst (Ireland) was 23 percentage points in the first quarter.3 

Last year’s winner could be this year’s loser. In 2020, China’s equity market posted a 30% return, beating nearly all other global markets.4 The following year, it fell 21%, underperforming emerging markets overall by over 20 percentage points. And Russian stock troubles this year are in stark contrast to last year, when Russia had the fourth-best returns among developing countries. As with stock picking, it’s hard to predict which countries will outperform. Dispersion in returns across countries is the norm and can seem like a reason to stay away from emerging markets. But diversifying across individual developing countries, using market-capitalization weights as your guide, can help lower volatility.

Navigating with Flexibility

Deciding to use global diversification to your advantage can be a good start, but determining which markets to invest in is another matter. How does Dimensional do it? We consider multiple criteria and apply flexible implementation to adjust to market changes. Emerging markets are constantly in flux, and using what we believe to be reliable criteria over time is key to our ability to evaluate and respond to market changes. Dimensional considers a variety of factors when evaluating a market’s eligibility for investment, including government regulation, restrictions on foreign investors, liquidity, and market size.

Applying Flexibility in Response to Market Changes

Based on this criteria, and the ability to access Russian stocks through depositary receipts, we added Russia as an eligible market for our emerging markets funds at the end of 2009. At the beginning of 2010, Russia made up nearly 4% of our Emerging Markets Core Equity Portfolio (see Exhibit 2). In 2014, Russia’s annexation of Crimea saw the imposition of sanctions on Russia; based on the heightened risk of additional sanctions, again applying the same criteria to determine market eligibility, we decided to reduce our portfolios’ weight to Russian stocks. More recently, we halted further purchases of Russian stocks in January 2022 in response to the rising risk of additional sanctions on Russia. At the time, our portfolios all allocated significantly less weight to Russian stocks than benchmarks did: While the MSCI Emerging Markets Index had a 3.2% weight in Russian stocks, Dimensional’s emerging markets funds had between 0.3% and 1.7%.

exhibit 2

Changing with the Times

Weight allocated to Russia: Dimensional Emerging Markets core funds vs. MSCI Emerging Markets IMI Index, September 30, 2007–April 30, 2022

Benefits of a Systematic Approach

Dimensional has been investing in emerging markets for nearly three decades—longer than 90%5 of the managers currently operating in the space. We launched the Emerging Markets Portfolio in 1994; it’s the 15th-oldest emerging markets fund available today.6 We were among the pioneers in value investing in developing countries, launching the Emerging Markets Value Portfolio in 1998. Benchmark providers like MSCI didn’t launch value-focused indices for another four years.

Dimensional has always taken a systematic approach to investing, including in emerging markets. A systematic approach can produce good outcomes even in a bad environment. Last year, major emerging markets indices lost value, with the MSCI Emerging Markets Index (net dividends) declining by 2.5%. Dimensional’s core emerging markets equity portfolios—which invest largely across the same set of stocks but systematically overweight those with higher expected returns (small cap, value, and high-profitability stocks)—all posted positive returns for the year. Our flagship Emerging Markets Core Equity Portfolio returned 5.8% as small cap, value, and high-profitability stocks all outperformed in emerging markets (see Exhibit 3).

exhibit 3

Higher Dimensions

Dimensional emerging markets funds and ETFs vs. benchmarks, 2021

Last year is a powerful example of the benefits of investing systematically in stocks of developing countries using robust theoretical and empirical research to underpin your investment approach. Emerging markets represent a meaningful piece of the market and offer investors an opportunity to diversify their portfolio. By applying a flexible and systematic approach, we can seek to capture value, even in challenging times.

Appendix

Performance information as of 03/31/22. Expense information as of the prospectus dated 02/28/22. Performance data shown represents past performance and is no guarantee of future results. Current performance may be higher or lower than the performance shown. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. To obtain performance data current to the most recent month-end, visit us.dimensional.com. Short term performance results should be considered in connection with longer term performance results.



Footnotes

  1. 1Emerging markets represented by the MSCI Emerging Markets IMI Index and the US represented by the Russell 3000 Index.

  2. 2Russian stocks as identified in the MSCI Russia Index.

  3. 3Data sourced from MSCI Emerging Markets IMI Index.

  4. 4See footnote 3.

  5. 5Based on funds in the US-based Diversified Emerging Markets Morningstar category as of May 13, 2022.

  6. 6See footnote 5.

  7. 7Performance information as of March 31, 2022.

  8. 8Fee and expense information as of the prospectus dated February 28, 2022.

  9. 9Assumed highest marginal tax rate in effect for capital gains and ordinary income. Income from funds managed for tax efficiency may be subject to an alternative minimum tax and/or any applicable state and local taxes.

Glossary

Depositary receipt: A negotiable certificate issued by a bank to represent a foreign company’s publicly traded securities. The depositary receipt trades on a local stock exchange.

Free float: The shares of a company that can be publicly traded and are not restricted.

Market capitalization: The total value of all a company’s shares of stock, calculated by multiplying the price of a stock by its total number of outstanding shares.

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