MONEYMATTERS: Outlook: Emerging markets in your portfolio

By Travis Gallton

The Daily Record Newswire

When it comes to constructing a long-term portfolio, you can never stress enough the importance of diversification and asset allocation. For the past 10 calendar years, the MSCI Emerging Market Index has outperformed the S+P 500 Index eight times.

Emerging markets are countries that are in the transition of industrializing and streamlining business activity. These markets are typically characterized by having cheap labor and an abundance to natural resources and commodities. The rationale that allocating a portion of your portfolio to international corporations can provide both return enhancement and risk reduction in context of the whole portfolio.

Let us first look at what is meant by return enhancement. For the past decade many emerging markets had experienced robust Gross Domestic Product growth rates of greater than 10 percent, which typically parallels into strong returns. We have seen GDP growth so strong that emerging economies have went from 32 percent of total world GDP in 2000 to 45 percent at the end of 2010. For comparison, the United States and Canada have seen their GDP fall from 33 percent to 26 percent of total world GDP in the same respective time. (Bloomberg Finance, LP)

Although emerging markets have provided wealthy returns, in 2011 we have seen multiple shocks cloud their outlook. Due to their traits of being commodity-driven suppliers, emerging markets tend to follow the business cycle of developed nations. In fact, any negative sentiment about economic strength of the G7 nations typically puts pressure on emerging market stocks.

Current headline news of both Europe and China has put growth prospects for the emerging markets into question. Eurozone sovereign debt crisis has been calmed by implementing a long-term refinancing option, which has lent substantial funds to peripheral nations in direct need of liquidity.

Emerging countries thrive on global trade and depend on European lines of financing. In addition, we have seen China announce decelerating GDP growth to 7.5 percent in 2012. China Premiere Wen Jiabao has been adamant about taming inflation by tightening standards on real estate in the country. Having growth slow in the world's second largest economy after a recent industrial boom will raise concerns of whether or not they have future sustainable growth.

Even with the financial markets showing tepid growth and high-risk aversion, emerging market funds have seen net inflows of $25.5 billion during the first quarter. (EPFR Global) Market fundamentals still point to emerging countries having stronger relative valuations compared to their developed counterparts. The countries have much lower levels of indebtedness and have seen recent periods of robust corporate earnings.

With return enhancement comes unique risks to emerging markets. They can exhibit unstable political and social environments, undeveloped infrastructure, currency risk and corrupt governments. These are areas investors must focus on before determining their optimal allocation to this asset class.

Emerging markets are dynamic in that they provide return enhancement and risk reduction by offering another layer of diversification benefits. However, those who have a weak tolerance for risk and are unwilling to accept their volatility might want to avoid these markets. For others, emerging market equities are an important component to developing a long-term, well-diversified portfolio.

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Travis Gallton is an analyst/portfolio manager for Karpus Investment Management, an independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. He can be reached at (585) 586-4680.

Published: Thu, Apr 19, 2012

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