Using aggregated Morningstar fund data (which includes U.S.-domiciled equity and bond mutual funds and exchange-traded funds) as a proxy for the average U.S. investor, as of August 2014, investors have about a 3% to 4% allocation in emerging-markets equities and just less than a 1% allocation in emerging-markets debt. These weightings are in line with what we see in some of the largest world-allocation funds, such as American Funds Capital Income Builder CAIBX and BlackRock Global Allocation MDLOX. Given the rising importance of emerging-markets economies, and their faster growth rates relative to the developed world, these allocations seem a bit low.
The State of Emerging-Markets Allocations
The main argument for investing in international securities is for diversification through exposure to different countries and economies, slightly different sector weightings, and foreign currencies. Using the Morningstar Moderate Target Risk Index (a global portfolio with a 60/40 mix of stocks and bonds) as a benchmark for the average investor, a target allocation to emerging-markets equities (including stocks from Taiwan and South Korea) would be 4.5% of the value of a 60/40 stock-bond portfolio, or about 8% of the equity portion of that portfolio. This 8% allocation is slightly below a market-capitalization-based weighting, as emerging-markets equities account for 10% of the global equity market, as represented by the MSCI All-Country World Investable Market Index. Regardless of how one measures market weight, these figures are all significantly below emerging markets' collective share of global GDP, which is approximately 35%. This figure provides some perspective on the asset class' long-term growth potential.
Investors who eschew emerging-markets funds in favor of broader international-equity funds generally have a very small allocation in emerging markets. According to Morningstar fund data, foreign large-blend funds have an average 8% allocation in emerging-markets equities, which is actually slightly lower than the 10% average during the last five years. This decline is partly due to emerging markets' relative underperformance during the last few years and a reluctance to rebalance, as emerging-markets equities continue to underperform and U.S. equities continue to outperform. Within the MSCI All-Country World ex USA Investable Market Index (a cap-weighted index of stocks from 45 countries, excluding the U.S.), emerging markets account for 20%.
Investors do receive indirect exposure to growth in emerging markets via developed-world large caps, such as Apple AAPL, Nestle, and HSBC HSBC. According to MSCI, about 21% of the revenue from large- and mid-cap stocks from the developed world came from emerging markets as of December 2011, up from 10% in 2002. While emerging markets are certainly a source of revenue and earnings growth for these companies, these firms are global multinationals and are generally more correlated to developed equity markets than those in developing economies.
As for bonds, the Morningstar Moderate Target Risk Index has a 5% allocation in non-U.S. bonds, with no specific allocation to emerging-markets bonds. At this time, we estimate the average investor has about a 1% allocation in emerging-markets debt, using Morningstar fund data. Emerging-markets bonds are a rapidly evolving asset class (more details can be found in my colleague Karin Anderson's article Combing Through the Emerging-Markets Debt Category). While most investors hold emerging-markets debt funds that invest in hard-currency (U.S. dollar or euros) bonds, the local-currency bond market is actually far larger. According to Bank of America Merrill Lynch, local-currency bonds account for 86% of the total fixed-income market in the developing world. Over the long term, faster economic growth and maturing financial-services industries (investing, insurance, retirement planning) will be secular growth drivers for emerging-markets debt. However, in the near term, fickle foreign fund flows can add another dimension of risk (see my article Hidden Risks in Emerging-Markets Debt? for additional details).
A Larger Slice
Jerome Booth, who recently retired from his position as head of research at Ashmore Investment Management, recently wrote Emerging Markets in an Upside Down World. In his book, Booth lays out a series of arguments for a larger allocation to emerging markets. Many of his fundamental arguments are well known by the investment community. Emerging markets account for more than 85% of the human population and the bulk of industrial production, energy consumption, and economic growth. And though emerging markets' contribution to global GDP is currently around 35%, Booth estimates that this figure will rise to 50% during the next decade. The savers and investors of tomorrow live in emerging markets, and they will be a major driver of the growth and maturation of local capital markets.
Booth's more interesting arguments are related to his view that current allocations are a reflection of an outdated and perhaps even inaccurate view of the risks present in and the importance of emerging markets vis a vis the developed world. Emerging-markets securities are believed to carry more risks given their higher levels ofobservable political uncertainty and corruption, and this, to some degree, is priced into local securities markets. While the developed world also carries risks, such as financial repression and its impact on investment returns, it is possible that they may not be reflected in securities' prices, as this will likely be a very slow and almost imperceptible trend.
Booth also discusses what he calls "Core/Periphery Disease"--the belief that the core (the developed world), as a source of demand for exports and a supplier of capital, has a significant impact on the periphery (the emerging markets). In fact, the emerging world is growing more interconnected through trade and financial links, which, in the long run, could reduce the role of the U.S. dollar as a global reserve currency. And with emerging-markets central banks holding about $2 trillion of U.S. debt, any significant reduction in these holdings may impact the value of the dollar and U.S. interest rates, which in turn could have an impact on the U.S. economy.
Medalist Funds
There are 19 Morningstar Medalists among the current crop of emerging-markets equity funds. Five emerging-markets debt funds have positive Morningstar Analyst Ratings. Our positive ratings (Gold, Silver, and Bronze) indicate that our analysts expect these funds to deliver above-average performance relative to their category peers over a full market cycle.
Morningstar does not provide Analyst Ratings for ETFs. However, the following funds are solid options for emerging-markets equity or emerging-markets bond exposure.
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