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A diversified portfolio is essential to long-term investment success. That's because a well-thought-out strategy helps investors earn consistent returns. And it reduces overall portfolio risk.
But there's more to diversification than adding different asset classes to a portfolio. Investors need a balanced approach to diversification. And this need goes well beyond simply placing income-producing securities into an equity portfolio.
That's because a properly diversified portfolio doesn't just expose an investor to different asset classes. It offers geographic diversification through exposure to emerging market (EM) economies as well. This mitigates an investor's exposure to the type of risk where some macroeconomic event affects all asset classes at the same time.
But not everyone agrees. Some investment advisers decry the need for exposure to emerging markets. They believe that EMs depend too heavily on developed economies. This dependence means that emerging market economies mirror the volatility of the developed nations. But they do so with weaker political and social contracts. This makes them less suitable for conservative investors.
A New Era
But these advisers are missing an important point. What was true in the past isn't true anymore. You see, emerging market economies have entered a new era. They are now the masters of their own fate.
This is very different from the days where emerging markets were commodity-based. This made EMs dependent on exporting goods to developed nations. Today, many EM nations operate as self-sustaining consumption-based economies, meaning that trade with other nations is icing on the cake to their economies. Gone are the days where developing countries relied entirely on developed nations to support their economies.
But even this understates the case for emerging markets.
Rising Middle Class
One interesting feature of EMs is the growth of the middle class. McKinsey Global Institute says that more than 4.2 billion consumers will enter emerging market economies by 2025.
Also, Euromonitor International estimates that 90% of the global population in EM and developing nations is under the age of 30. Africa and the Middle East lead the way. A growing population of motivated, socially connected, and wealthy individuals will drive consumer spending to more than $30 trillion annually by 2025. Those numbers will more than double by 2050.
These statistics reinforce data from the World Bank that expects real growth rates of just 1.6% in developed economies. But the World Bank expects EM economies to grow by more than twice that rate during the same period.
And this is no minor fact. You see, extrapolating from these numbers means the GDP of the E7 countries will be twice as large as the GDP of the G7 economies by 2050. And get this: Six of the seven largest economies on earth will be part of the E7.
However, this doesn't mean investors can invest in emerging markets the traditional way.
Avoid The Top-Down Approach To Emerging Markets
Investors traditionally gained exposure to EMs through indices buying stocks in large companies and institutions. But this method will produce lackluster returns going forward.
Investors must focus on specific sectors and companies that drive investment returns in these growing economies. Investors who identify long-term, secular opportunities among EM economies will earn outsized returns. This is especially true for investors with longer time horizons.
But there's an important concept to remember. Investors must concentrate on companies benefitting from growing technology, consumer consumption, and infrastructure spending in the emerging markets. These are the areas with the greatest potential for profit.
Making EM Investing Easier
For investors without the time or inclination for active management of their emerging market portfolio, there is an alternative.
Vanguard Emerging Markets Stock Index Fund Admiral Shares (NASDAQ: VEMAX) offers investors a low-cost way to gain equity exposure to emerging markets. The fund invests in stocks of companies located in emerging markets around the world, such as Brazil, Russia, India, Taiwan, and China.
The fund returned a whopping 31.4% before taxes in 2017. It returned an after-tax basis profit of 25.2%. Most importantly, VEMAX accomplished these returns rather cheaply. The fund is a no-load fund with an expense ratio of 0.14%. And compared to the category average of 1.29% -- VEMAX is significantly cheaper than its peers.
But that's not the only way VEMAX beat its peers. You see, with a five-year beta of 0.96, the fund is hypothetically less volatile than the market at large. And compared to other emerging market funds, VEMAX is more than 30% less volatile, making it easy to sleep at night.
Emerging markets will provide horsepower to the engine of global growth over the next several decades. They are a compelling long-term opportunity for investors. But the opportunity comes with risk that must be mitigated by avoiding traditional EM investing techniques.
Risks To Consider: Rising interest rates historically impact emerging market economies more than developed economies. Given the Fed expects to continue its quantitative tightening, there is some risk that emerging markets will suffer in the short term. But with the population and growth trends of emerging markets, the risk is short-term and manageable.
Action To Take: Dollar-cost average into VEMAX over the next 12-18 months. Mitigate the risk to your portfolio by using no more than 5% of your portfolio to emerging markets. This is a long-term secular investment, so you should expect to hold this position for more than five years.
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