Several years ago, I discussed the benefits of crafting an emerging markets investment portfolio predicated on weighting equally each of the constituent countries. Among the benefits of such a strategy, I argued, would not just be superior returns, but also lower volatility, and shorter, if not shallower, drawdowns.
However, the strategy has lagged in recent years, with the MSCI Emerging Markets Equal Country Weighted Index trailing the parent MSCI EM index by more than 200 basis points annually over the last three years ending in April. Given this extended period of weak performance, and given the massive changes in the composition of the EM index away from sectors such as commodities and energy to consumer-oriented and technology stocks, does equal-weighting by country still have an argument?
First of all, it should be restated that emerging markets are a very dynamic and ever-changing group of countries for which the risks involved are considerably different from developed markets. Whether the risks in a given country are political (authoritarianism), legal (property rights), or economic (inflation), the history of emerging market returns shows that investing in them can be lucrative, but also fraught with risks that are, by comparison, considerably greater than in most developed markets.
A scatterplot of the last 24 years of emerging market country returns shows just how varied the returns (USD basis) and volatility have been from one EM country to another:
In the graphic above, I have grouped the nations by what I consider to be a common risk for investors in these nations, with, for example, Russia, Turkey, and China being grouped together because of their authoritarian governments, and the former “Asian Tigers” grouped together because of their common economic malaise during the currency contagion of the late 1990s. As can be seen, some EM nations like Hungary and Russia delivered similar returns, but with far different realized volatility. On the other hand, nations like Malaysia and Taiwan had less volatility than the top performers, but underperformed the index. The index itself realized less volatility than any individual country, but the returns lagged half of its constituents.
Because MSCI’s equally-weighted EM country index has data going back only to 1998, I simulated an index going back to December of 1994, the same start date as the data in graphic above [Note: I rebalanced the portfolio annually, whereas MSCI’s country equal-weight index rebalances semi-annually.] The annualized return of this simulated index was 9.74%, with a standard deviation of 21.75%. These compare favorably with the parent index’s 6.4% annualized return with slightly higher volatility (22.5%).
Furthermore, a study of the drawdowns for the indices shows that the country equal-weighted index recovered much more quickly from severe drawdowns (USD basis) than the parent index:
Without running a regression, it can only be assumed the equal-weighting by country works well for the same reasons that equal-weighting generally works in almost any instance: more exposure to value, and size, at the expense of momentum exposure. However, in this instance, equal-weighting by country across emerging markets, by virtue of its implicit rebalancing, ensures that investors have less exposure to potential blow-ups as with what happened with the Asian nations in 1997-1998, or with the commodity-based nations in 2007-2008. On the other hand, equal-weighting ensures at least constant and steady exposure to these depressed markets once their recoveries, – typically strong, – come along.
In sum, as with any strategy, investors should be prepared for periods of underperformance against the benchmark. However, I think a strong case remains for diversifying the unique risks involved in emerging market investing by spreading exposure as much as possible, and rebalancing accordingly.