But the second point to make is that we have tried to learn the lessons of history with regard to how to use value to actually outperform. As I wrote a few years ago in “Divesting when Discomfited” and touched again on last year in “Keeping the Faith,” one of the key aspects of value as a selection technique is that lagged value works every bit as well as – and sometimes better than – today’s value. As a result, when putting together our portfolios we react not just to today’s forecast but to the average of the forecasts over the last year. And on this basis, emerging value has done something fairly remarkable. Emerging value today is not the cheapest we have ever seen it; not only was it cheaper at the beginning of the year and at some points in 2016, but it was significantly cheaper than today in both the financial crisis and the 2002-03 period. Actually, in February 2009, almost every single risky asset class we had a forecast for had a higher forecast than emerging value does today!2 But, on a measure that really matters to us for portfolio construction, emerging value today is the best asset we have ever seen. That measure is its “margin of superiority” – the amount by which it is better than the next best asset on our forecasts.3
As you can see, much of the time our favorite asset is only a little better than the next best. On those occasions, the cost of diversifying from our favorite asset is fairly low and the benefits of diversification tend to dominate. Of course, we should own plenty of our favorite asset, but not necessarily a lot more than we own of the next best. Today, emerging value is a lot better than anything else, so the drop-off in expected return going from it to the next best asset is severe. How much of it should we hold? That answer, in the end, must come down to risk.
The risk of emerging
There is little question that emerging market value is not only a risky asset, but probably the riskiest of the risky assets we routinely buy in our portfolios. We should expect worse performance from them in the event of a global economic crisis than even other types of equities. Furthermore, emerging economies are subject to home-grown crises, and in periods like 1997-98 or 2014-16 have shown themselves capable of substantial losses even when other risky assets are doing well or at least a lot less badly.
But depending on your definition of risk, 1997-98 was either a big problem or a small one. Let’s first think in terms of running an equity portfolio against an MSCI ACWI benchmark.4
If your view of risk as a portfolio manager is underperforming ACWI, the worst thing that ever happened to emerging was the period from the summer of 1997 to the fall of 1998. In that period, ACWI rose by 4% and MSCI Emerging fell by 48%. It’s a stunningly bad event in relative terms.5
If that didn’t cause equity managers to recognize the risk of betting on emerging, I don’t know what it would take! You could say that it was just as bad in absolute terms, and in a sense that is true. A 48% absolute loss is a big deal in anybody’s book. But given that it was basically an emerging-specific problem, the loss was unlikely to lead to a big drawdown in your overall portfolio. Exhibit 2 shows the returns to various assets during the time period of emerging’s disaster.