Emerging markets have been a staple for at least a decade among investors who value portfolio diversification. The asset class went mainstream in the mid-1990s with the launch of a variety of mutual funds targeting the stock markets in the developing world.
The last several years have been especially sweet for the asset class, delivering double-digit gains for three years in a row through 2005. This year doesn’t look too shabby either. Despite the correction in the MSCI Emerging Markets Index earlier this year, the stocks are up nearly 14% so far in 2006 through yesterday.
Adding luster to the asset class is the growing stack of research that sings a familiar song: emerging markets stocks are a valuable diversification tool for conventional domestic stock/bond portfolios. A familiar argument is of a type found in an essay by George Hoguet, the emerging markets investment strategist at State Street Global Advisors. Diversification, return enhancement and a general expansion of the so-called investable opportunity set are the main benefits, he wrote. In the long term, Houget counseled, “adding emerging markets to your portfolio can both increase return and lead to diversification.”
Houget’s far from alone in promoting emerging markets of late. That’s the nature of bull markets. But while the crowd loves the asset class these days, Jeff Troutner has another view, namely: emerging markets haven’t lived up to expectations and so it’s time look elsewhere for diversification benefits.

Emerging markets have delivered mediocre returns, high volatility and rising correlations with U.S. stocks during 1994 through 2005, wrote Troutner, who runs TAM Asset Management, in the August issue of his newsletter Asset Class.
Inspired by an article penned by financial planner Bill Bernstein, Troutner crunched the numbers and found that emerging markets delivered an annualized return of 6.5% for 1994-2005. That’s a fraction of the 45.1% annual gain logged in 1988-1993 (returns are based on the DFA Emerging Markets Equally Weighted index). It was in the mid-1990s, in fact, when Troutner first started putting clients into emerging markets. It all looked so enticing back then. Not only were trailing returns stellar at the time, the correlation between emerging markets and the S&P 500 was only 0.25 (0.0 is no correlation, 1.0 is perfect correlation). Yes, volatility was high, but that was tolerable, given the expected diversification and return boost from emerging markets.
But the asset class stumbled, Troutner discovered. Correlation with the S&P 500 rose to 0.67 for 1994-2005 while the average annual return for the asset class sunk to 6.5% during that stretch. Meanwhile, volatility remained high.
What’s behind the stumble? Perhaps the rising popularity of the asset class diminished its formerly alluring profile? It wouldn’t be the first time that a hot new asset class attracted loads of money only to fall short of expectations later on. “That could be,” Troutner told us yesterday in an interview on the chance that popularity killed this golden goose of an asset class. “I think that it could be a lot of hot capital flowing in and out of these markets. It’s flighty capital,” he reasoned. “As an investment advisor, I’m asking, why, from 1994 to 2005, were the returns [in emerging markets] so crummy? I think it is speculative money, for the most part. And speculative money moves fast. If speculators believe a market’s going to drop, they pull their capital out.”
Speculators have a hand in every market, of course. So, why are emerging markets any different? “Because I think there’s a hell of a lot more investors in U.S. stocks than speculators on the whole; but in emerging markets there are far more speculators than true investors.”
Troutner also said that “investors don’t think about the fact that bidding up the prices of high-growth investments lowers expected returns.” Emerging markets are considered high-growth investments, of course. But everyone knows that. As a result, high growth doesn’t necessarily lead to high returns. “A lot of capital’s gone into these markets in anticipation of higher growth, and that’s driven up prices and therefore expected returns are lower.”
Whatever the reason, the asset class no longer impresses Troutner. He’s not rushing for the exits, although he said he’s no longer putting new clients into emerging markets. And for established accounts, he’s selling into strength. As he told CS:
“I’m asking the question: Should we continue to invest in emerging markets. My inclination is to say ‘no.’ Emerging markets are on a watch list for me. They’re on probation.”
What, if anything, could replace emerging markets? Small value stocks in the U.S. and in developed countries are a good alternative, according to Troutner’s analysis, as per the chart below. “I can invest in U.S. small value, and get almost as high returns with half the volatility of emerging markets.”

Source: Jeff Troutner, Asset Class, Aug. 2006.
Of course, with emerging markets still firmly in the black this year, the crowd isn’t likely to follow Troutner’s lead. Not today, anyway. But somewhere in the future another bear market lurks, along with a fresh round of attitude adjustment for the masses.