Head of Global Equities - Citi Investment Management
Zeshan Azam, Equity Portfolio Manager, Citi Investment Management
January 18, 2017
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Valuations suggest that emerging market equities might outperform their developed market counterparts on a ten-year view. But many US investors may be underexposed to emerging markets.
US equities have performed strongly over recent years. Since 2011, the S&P 500 Index has produced an annualized total return of 14.2%, compared to 6.2% on the same basis for the MSCI EAFE Index, which tracks large- and mid-cap equities in twenty-one developed countries outside of North America. Partly as a result of this, the average US investor now has an 84% allocation to US equities, even though they make up only 53% of world market capitalization. Such a lack of diversification leaves investors exposed to any reversal in the performance trends of recent years and to potentially larger drawdowns in a market dislocation.
One consequence of the strong performance of US equities is that they are now expensive by historical standards. The S&P 500 trades on around 27 times average inflation-adjusted earnings for the last ten years. Only during the technology bubble of the late 1990s and roaring bull market of the late 1920s were US equities more expensive. By contrast, the MSCI Europe Index trades on a multiple of 16.2, with markets including the UK, Spain, and Italy on even less. Our strategic asset allocation methodology recognizes that high valuations have subsequently tended to give way to low returns and low valuations to high returns.
Equities in many international markets may also currently offer more potential opportunities to earn income than those in the US. The dividend yield on the MSCI EAFE Index currently stands at 3.2%, whereas that of the S&P 500 is 2.2%. Various individual markets offer even higher yields. For example, the UK market offers an average yield of more than 4%. In an environment where earning a yield has become especially difficult, the potential downside of allocating too much to a single low-yielding market is clear.
Taking a long-term view, our strategic asset allocation methodology estimates that emerging markets may deliver higher returns than those of developed markets, of which the US is the largest. Over the next ten years, its annualized total return estimate for emerging equities is 10.8% compared to 6.3% for developed market equities. Some emerging markets have more favorable demographic profiles than the US – with younger populations set to assist economic growth in the coming years – which may add to the case for holding equities from these countries alongside an allocation to US and other developed equities.
The ability of active managers to outperform benchmarks has become a hotly debated topic. As markets have become increasingly efficient and less volatile and information more freely disseminated than ever before, risk-adjusted outperformance has become a difficult proposition in domestic markets. Internationally, however, active management can still add value to a client's portfolio. Many emerging markets are still relatively inefficient, owing to less stable political climates, greater illiquidity, and currency volatility.
In such an environment, able active managers can potentially find more opportunities. Also, often-faster growth rates and demographic trends may provide a more favorable investment backdrop. In fact, research corroborates active management over passive management in international markets. In Abhay Kaushik’s study in the Journal of Investing titled "Performance and Persistence of Actively Managed US Funds that Invest in International Equity", the author concludes that active managers do add value over index returns sufficient to cover fees. Thus, in the context of allocating funds to international markets, an active strategy is a more compelling proposition over a passive allocation for a client.
Source: Citi Private Bank Global Asset Allocation Team. SREs as of 30 November 2016; Returns estimated in US Dollars; All estimates are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Strategic Return Estimates are no guarantee of future performance. Past performance is no guarantee of future returns. For more information on SREs and our asset allocation methodology, please see Adaptive Valuation Strategies 2016 Annual Update.
There may be additional risk associated with international investing, including foreign, economic, political, monetary and/or legal factors, changing currency exchange rates, foreign taxes, and differences in financial and accounting standards. These risks may be magnified in emerging markets. International investing may not be for everyone.