GMO: Emerging Value and Margin of Superiority

GMO: Emerging Value and Margin of Superiority




Other than emerging equity and debt, this was a pretty decent time to be an investor. When one thinks about the real risks for a long-term investor, the risks that really matter are events that cause sufficiently acute losses across the portfolio to require a behavior change in spending, or events that cause losses that are not reversed even in the long term. The 1997-98 loss, as bad as it was for emerging, has not meant any permanent loss for emerging market investors.

Since the start of 1997, MSCI emerging has mildly outperformed ACWI, even including that large drawdown. As for emerging debt, the other material loser in the period, since 1997 it has been the best performing of all of the asset classes we track, despite its losses in 1997-98. Emerging equities and debt are volatile assets and move somewhat to an “emerging” rhythm. This means that the potential for them to underperform other assets is quite material, but so is their ability to beat them. In other words, for an investor more concerned with absolute risk and return than relative, they can offer valuable diversification.

But let’s not kid ourselves. Emerging is also a risky asset that can be relied upon to perform poorly in events that really do matter. From the 2007 high for ACWI to the 2009 low, ACWI lost 55%. MSCI Emerging lost 62%. This may not sound like a big difference, but in order to recover the losses, ACWI had to rally 122%, whereas MSCI Emerging needed to rally 160%, a difference of 38 percentage points.

So for an investor focused on absolute return and risk, emerging is a risky asset class – let’s say a factor of 1.2 on platonic “equity depression risk,” although that is only an educated guess. But the fact that it is also capable of large losses at times when other assets do just fine is not necessarily such an issue. Even on the “Hell” version of our forecasts, where returns to all equities are higher, emerging market value stocks have an expected real return about 2.4 times higher than the next best equity group. On the “Purgatory” version, the ratio is 5.4 times.6

A return multiple of over 2.0 and a risk multiple of 1.2 argues for owning emerging equities to the exclusion of all other equities.

Why not go all the way to that, with perhaps 50% of our portfolio in emerging equities and no other risky assets? This portfolio would have similar “depression risk” to a standard 60% stock/40% bond portfolio and a hugely higher return on our forecasts – about 5% better than the traditional portfolio for the next 7 years. One reason not to do this is that this takes the “emerging-specific problem” event and turns it into a really meaningfully nasty event for the portfolio. If there were another -48% return from emerging such as we saw in 1997-98, we wouldn’t be bailed out by the performance of other assets in the way a diversified portfolio would be.

Even if emerging came back as it did after that crisis, a 25% overall portfolio loss is a big loss. And just as important, given the fact that the large loss would come from a single volatile asset class, I’m also willing to bet that it would be a large enough loss to cause pretty much any investor (including GMO) to think twice about rebalancing into the pain, which is generally the right thing to do in such events. So let’s agree that 50% is too large a position. What is the right size? Given the size of the expected return premium for emerging value over everything else, it’s not really driven by the expected return gap but by risk.

The risk of emerging today

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