AFTER DEPARTING the U.S. stock market for the greener pastures of emerging markets, I recently hit a pocket of turbulence. Although emerging market stocks are virtually unchanged year to date, they fell as much as 12% in August compared to the recent highs reached in February. By contrast, the S&P 500 is up 17% for the year, with barely a pullback along the way.
The travails of Chinese stocks explain much of this underperformance. In August, Beijing managed to eradicate 90% of the market value of Chinese online tutoring companies trading on the New York Stock Exchange. It also expressed its displeasure with online gaming companies. And last week, Beijing announced plans to break up Ant Group’s Alipay, which weighed heavily on shares of Alibaba.
Such are the risks to investing in countries where the rule of law is applied unevenly, to put it mildly. Does this mean I’m bailing out of emerging markets? Well… no. Emerging market stocks trade at a discount to those in developed markets for a reason. Investors rightly demand a higher risk premium for the greater uncertainty and volatility. This leads to lower stock market valuations, all else being equal.
But therein lies a fine point that eludes many. A higher risk premium also equates to higher expected returns. In fact, the higher discount rate used to price future cash flows reflects the additional expected return. Of course, those returns are not guaranteed. If they were, there wouldn’t be any risk.
Here’s the point: Emerging market stocks today offer significantly higher expected returns than U.S. stocks, in part because they’re historically cheap but also due to their greater risk. Investors’ perception of risk—heightened by recent events—led to a repricing of stocks. That raises expected returns. As always, investors are compensated for taking on more risk, real or perceived.
The risks in emerging markets are real. That’s why diversification is paramount. This can be achieved through diversified emerging market funds, which invest in hundreds of companies located in dozens of countries. Nobody’s entire stock portfolio should be in emerging market stocks—they’re far too volatile for that. But short-term volatility is the unavoidable price investors must pay if they hope to garner higher returns. There is no free lunch.