Investors this year are receiving yet another lesson on risk, this time in connection with emerging markets, which have taken it on the chin so far in 2013. The MSCI Emerging Markets Index is lower this year by roughly 14% through yesterday (August 28) while US stocks (S&P 500) are up nearly 15% and foreign developed-market equities are higher by almost 7% on a year-to-date basis. The fact that some markets are down and others are up isn’t surprising, but the relatively wide spread in performance numbers this year offers another excuse to consider why beating an unmanaged, market-value-weighted portfolio of all the major asset classes is so tough for any length of time.

As I discuss periodically on these pages, a market-weighted mix of everything (or something approximating the full boat of risky assets) routinely dispenses competitive returns vs. a wide array of actively managed mutual funds and ETFs swimming in the asset allocation waters. A recent update on the numbers, based on 1,100-plus multi-asset class products vs. my Global Market Index (GMI) over the past 10 years, speaks for itself, time and time again.
In order to outperform GMI, you have two basic choices. One is to choose different weights for the asset classes compared with the market-value weights that are a constant in GMI. You can also rebalance, which Mr. Market avoids. In fact, you can apply both of these techniques. Actually, there’s a good argument for engaging in both activities for reasons that are bound up with the goal of building portfolios that match an investor’s particular objectives, risk profile, etc. The question is how far from Mr. Market’s strategy do you want to travel?
The more your portfolio deviates from GMI, the bigger the risk tilt. Again, there are sound reasons related to risk management for building customized asset allocation strategies. That said, most folks should avoid the temptation to radically restructure GMI’s allocation and/or engage in aggressive rebalancing techniques on the assumption that they’re smarter than the average investor. History demonstrates quite clearly that it’s tough to generate benchmark-beating returns (vs. a relevant benchmark) through time without taking big risks. The main reason is that alpha (benchmark-beating performance) is finite, and so the winners reap the rewards at the expense of the losers. Beta (via Mr. Market’s portfolio) is forever in the middle. Actually, he tends to be above-average by a fair amount, thanks to the additional real-world frictions of trading costs, taxes and other factors.
That brings us back to emerging markets. In connection with a consulting project, I was recently reviewing the numbers on a broad set of actively managed equity funds with global mandates. Not surprisingly, the funds that were doing relatively poorly this year tended to have comparatively heavy weights in emerging markets. Yet the literature published by these funds emphasized the stock-picking capabilities of the managers. But after running a factor analysis on the return histories, it was clear that the decision to overweight emerging markets was the key decision weighing on the funds, and not necessarily for the better… this time.
That’s not to say that you should never second-guess Mr. Market’s allocations. Indeed, slavishly replicating market-value weights isn’t practical, or even relevant. Rather, the issue is considering a robust benchmark that applies to your investing goal and deciding if you’re comfortable with radically restructuring a passive allocation. For some perspective on the numbers for global equities, here’s how the market-based allocations stack up as of yesterday, courtesy of S&P Global BMI data.
In the first table, we see that foreign stocks generally represent a bit more than half of the global equity pie:

Breaking down market weights by US, developed, and emerging categories reveals that emerging markets take a roughly 9.5% share at the moment:

And if we slice up the emerging market category by region we find that well over half of the market cap is in Asia:

The implied question: What’s your view on allocating capital across equity markets? As history reminds, that’s a loaded question. I’d guess that a fair number of the leading performers among global equity funds so far this year have relatively light allocations to emerging markets, and vice versa. The next question, of course, is: Why? Skill? Luck? A combination of both? Was the higher or lower emerging-market allocation intentional in the first place?
The bottom line: choices about beta are still the main risk factors to consider for designing and managing asset allocation. This critical point is still poorly understood across the broad spectrum of investors, professional and otherwise. But ignored or overlooked, intentional or not, beta choices, for good or ill, are still destined to dominate your portfolio’s risk and return profile. Surprisingly, this is still a radical notion for some (many?) investors. My response to the skeptics? I’ll just quote a line from the classic film noir “Chinatown,” in the scene when Noah Cross (played by John Huston) tells Jake Gittes (Jack Nicholson): “You may think you know what you’re dealing with, but, believe me, you don’t.”