Emerging market stocks will generate about a 3% premium above developed market stocks, according to a recent report from AQR that’s cited in an Institutional Investor article, thanks to fundamentals that have been slowly improving in emerging markets over the years. From 1980 to 2020, the gap between the economic output of developed and emerging markets has shrunk substantially, with the GDP per capita in emerging markets shooting from 20% to more than 50%.
Emerging markets haven’t been a top performer since the financial crisis, leading many active managers to decrease their allocations to them. The MSCI All country World Index holds 12.2% in emerging market stocks while on average actively managed equity funds have 8.8% allocated to emerging markets, according to eVestment data that is cited in the article. That low allocation is likely due to the fact that the trailing 10-year yearly return of U.S. stocks surged far ahead of that of emerging markets, but AQR predicts that trend will reverse itself in the next few years. Emerging markets are not as volatile or risky as they once were, and the trailing 5-year volatility of emerging market stocks is about the same as developed markets, currently around 20%. And emerging markets offer more diversification benefits now, as the correlation between developed market equities and emerging market stocks has narrowed; in 1999 it was 0.87 while last year it was 0.77.
So while investors are probably under allocated to emerging markets, AQR’s report suggests that current valuations offer an opportunity for investors to garner returns, something that could be “especially useful in today’s low expected return environment,” the article quotes from the report.