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Jan 20

The Problem With Diversification – Emerging Markets

by Rockbridge Team

One of the tenets of successful long-term investing is the practice of portfolio diversification.  Through diversification, investors can increase their expected long-term return for a given level of risk (volatility).  This is accomplished by investing in assets that are not perfectly correlated to one another, but each asset individually has a positive expected return.  This theory is the basis of Modern Portfolio Theory (MPT).  Because underlying assets in diversified portfolios are not perfectly correlated, one problem with diversification is that there will always be something investors wish they didn’t own.

Emerging markets was one of the worst performing asset classes in 2015, returning a negative 14.6% for the year (as evidenced by the MSCI Emerging Markets Index).  If foresight were 20/20 at the beginning of the year, we clearly would have avoided a commitment to this asset class.

On the other hand, at the start of 2015, the best data source we had available for predictive purposes was the past behavior of the asset class.  Over the 15 years prior, the MSCI Emerging Markets Index returned approximately 10% annually and exhibited a standard deviation (risk) of 23% (based on monthly returns).  As important as its risk/return behavior, this asset class has not been perfectly correlated with other assets in which we invest, so it was expected to offer diversification benefits.  (Note this time period was used because it was the earliest data available for this Emerging Markets Index.)

Interestingly, the most similar asset class, with respect to risk and return over the same time period, was U.S. real estate (as evidenced by the Dow Jones U.S. Select REIT Index).  This asset class returned approximately 12% and exhibited a standard deviation of 23% as of 2014 (compared emerging market returns and risk of 10% and 23%, respectively).

Given the similarities between the asset classes at the end of 2014, an argument could be made that the 2015 returns might be expected to be similar.  Interestingly, they behaved extremely different in 2015.  U.S. real estate exhibited the best returns of the underlying asset classes, with the Dow Jones REIT Index returning a positive 4.5% for the year (versus the negative14.6% for emerging markets).  This return difference is more attributable to the lack of correlation between the two assets, in addition to their exhibited risk.

Since there is no evidence of investors being able to consistently outperform the market or predict the best asset classes (prior to outperformance), diversification continues to be the best alternative for successful long-term investing.

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