Sunday, July 19, 2015

What If Emerging Markets Eat Our Lunch?

Source: Stocks for the Long Run by Jeremy Siegel (5th Edition), Page 65

If you are unfamiliar with the term “GEM” please refer to the performance tab of this website for more information.

I was reading Jeremy Siegel's classic book Stocks for the Long Run in greater detail today. In it, there's a chart for projected share of world GDP by country (above) that has me thinking. This chart suggests that emerging markets may produce a larger % of world GDP: from 45% currently, to possibly 70% in under 3 decades.

I have no doubt stocks should be the core of GEM (I'll explain this in a separate post), but the question is whether US vs. non-US stocks is the right split for GEM. Based on the chart above, wouldn't it be better if GEM’s split is developed vs. emerging market stocks?

First, GEM’s creator Gary Antonacci points out the problems with emerging markets as a core holding:
  1. Very high and unusual volatility
  2. Low liquidity/high transaction costs
  3. Accounting unreliability
  4. High fund expense ratios
  5. Limited market history

Second, I want to show how the current GEM setup (which uses a US vs. non-US stocks split) would be able to take care of the economic scenario shown in the above chart. Here’s three reasons how:

  • If emerging markets grow faster than developed countries, then the country holdings of ACWX (the ETF representing non-US stocks in GEM) would shift accordingly. This is the beauty of the GEM strategy as momentum is even working on the ETF level: Strong countries gain a larger share of ACWX while allocation to weak countries shrinks.
  • Developed countries are increasingly generating revenues from emerging markets, so this helps partially offset risk of growth slowing in the developed world. 
  • Siegel points out that as an increasing number of people in developed countries retire, their assets would be bought by increasingly wealthier investors in emerging markets. Yes, I know, this is a shocking realization. But it would keep the assets of developed markets in demand over the long-term.

To summarize, it would be wrong to replace ACWX with EEM (the ETF for Emerging Markets) today in anticipation that China and India may dominate world GDP in the future.  You should never fine-tune your strategy based on one specific economic scenario. Instead, you should ensure that your strategy is robust enough to handle a wide range of scenarios, one of which is the one shown in the above chart.

In a future post, I will show how GEM is robust in different currency environments as well. More to come, stay tuned!

4 comments:

  1. I use VWO, VEA and VTI. Take the one with highest momentum provided it is greater than BIL.

    I agree that it would not be a good idea to replace non-US with EM, but i am not sure splitting the world into 3 instead of 2 would hurt performance.

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    Replies
    1. Hi Paul, thanks for the comment.

      I wrote a post after this one called "Markets are Interconnected." It's a rather long & tortuous post but it explains how GEM's split between US and non-US stocks is the best. This is because the ratio of US to non-US stocks is highly correlated with the US dollar, which in turn is correlated with commodities. Therefore, by switching between US and non-US stocks, you are profiting from USD and commodity cycles.

      If you instead split GEM between developed vs. emerging stocks, you wouldn't get as much of that extra boost from USD cycles. On top of that, having a 100% allocation to emerging stocks will mean your portfolio will be volatile. I recommend that you backtest your idea.

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    2. OK, I just backtested your idea using these equity indices:
      - S&P 500 Index
      - MSCI Developed World ex-USA Index
      - MSCI Emerging Markets Index

      All data is total return with gross dividends. Backtest period was limited to start from end of 1987 due to the emerging markets index.

      From 1987-Present:

      1. Modified model (with Emerging Markets): 17.5% CAGR, 19.1% avg annual return, 17.0% volatility and 0.83 Sharpe Ratio.

      2. Original GEM: 14.9% CAGR, 15.4% avg annual return, 12.3% volatility and 0.85 Sharpe Ratio.

      Since the Sharpe Ratios are the same, there's really no benefit from your approach. The original GEM with 20% leverage would have produced the exact same results as your approach (with fewer trades).

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  2. Thanks. I apreciate the thoughtful response. It looks like a wash although practically speaking there would be a cost to the leverage.

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