Losing Sleeping Over Emerging Markets? Try Low-Volatility ETFs

Roger Nusbaum
June 27, 2013

NEW YORK ( TheStreet) -- In the last few weeks the idea of maintaining a diversified portfolio has taken a beating, especially where emerging markets are concerned.

Since mid-February the iShares Emerging Market Index Fund is down 12%, vs. a 6% gain for the SPDR S&P 500 .

That lag has intensified since the high for the S&P 500 in early May. Is this reason enough for investors to abandon emerging markets in their portfolios?

The first question to ask is: What is the purpose of investing in emerging markets? Most people will answer that emerging markets help investors diversify their portfolios away from domestic stocks and capture promising long-term growth.

People looking for superior diversification are buying an asset class they expect to add value to their long-term investment results, but no asset class can always outperform another asset class.

Over the last 10 years, EEM is up 186%, vs. 65% for the SPY. Although value has clearly been added over that time, the last 10 years include several periods of meaningful performance lags.

Some may remember the Asian Contagion from 1997 in which the Vanguard Emerging Markets Stock Index Fund dropped 33% in four months. In the next four months, VEIEX then went up 81%. EEM did not exist then, but they are both proxies for the same thing.

Periods like the present, when emerging markets lag, have happened many times in the past and will happen again in the future, but there is still long-term potential value.

Whatever sense of concern there is now about the future of emerging markets, it was far greater in 1997. The Asian Contagion was not the end of emerging markets, and neither is the current market downturn.

Investors looking to capture favorable long-term growth prospects must realize that growth in all countries is subject to economic cycles. The timing of cycles in different countries will sometimes be different than those of the U.S., but when any economy enters a period of slower growth or contraction, then that is when the corresponding stock markets are likely to turn down.

That doesn't invalidate a country's long-term growth prospects. If a country has resources to export, a young aspirational population and an ascendant middle class when its economy is booming, it will still have those positive attributes during a slowdown.

Of course there are reasons to sell an emerging market, such as a government's mismanagement of its economy. This may be happening in Brazil right now.

Another reason to sell emerging markets broadly would be to rebalance. Someone targeting a 15% allocation to emerging markets in his or her equity portfolio would have needed to rebalance several times in the last 10 years given the dramatic outperformance.

In light of world events of the last decade, investors might reasonably be shell-shocked from all the volatility. This is clearly an emotional response, but investors do need to be able to sleep at night. In the last few years, ETF providers have developed a new broad index niche with low-volatility funds in many market segments, and they have generally done what they are supposed to do.

As EEM has gone down 12% in the last four months the iShares MSCI Emerging Markets Minimum Volatility ETF has declined only 7%.

The idea with these funds is to damp volatility; EEMV is not going to go up in the face of a decline for EEM, so in that light, the low-volatility fund has done its job. Of course, you need to understand that if EEM goes up 50% in the next six months, EEMV will go up less than that. The tradeoff for less worry during a market panic is a smaller move higher during a big rally.

The potential long-term diversification benefit from emerging markets is still important, and minimum volatility funds will make it easier for more investors to participate.

At the time of publication, Nusbaum had no positions in stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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