Investors should be wary of investing in emerging markets based on expectations of economic growth, as it is not a sure predictor of equity returns, although they can still offer diversification benefits, says the Credit Suisse Global Investment Returns Yearbook, by professors from London Business School.

While months and even years can be very volatile, especially in times of big market dislocations, the latest Investment Yearbook, published this week, aims to frame the issues of emerging markets and the link between equity returns and economic growth in a long-term context, using historical data.

This is particularly relevant at the moment with the hype around emerging markets’ growth prospects, and on the heels of rallies in these markets which have seen yields fall close to those of developed markets and may leave investors wondering if they still represent good value.

“While there are lots of enthusiasts who sell the emerging market concept…it is important to distinguish the arguments that hold water from those that don’t,” said Elroy Dimson, Emeritus Professor of finance at London Business School and contributor to the report.

Arguments in favour of emerging markets tend to be that they offer diversification benefits and better growth prospects, while they are no longer high risk investments.

The report supports the argument that in the aggregate they are no longer riskier than developed markets, while at the same time they have delivered superior returns over the last decade.

“Those reporting that the last decade was a lost decade for equities are reporting about developed markets,” said Mr Dimson, because while the Morgan Stanley Capital International world index delivered close to 0 per cent for the period, the MSCI emerging index delivered 10 per cent per annum. However, over the period from 1976-2009, emerging markets underperformed the world index by 1 per cent annually. 

Measured over the past 120 months, Mr Dimson said emerging markets represented a “geared play” on the world stock markets, as they have been high-beta and tended to amplify gains and falls in the world index.

The diversification story, meanwhile, was supported by the data, although this effect is getting smaller over time.

“There has been an increase in the propensity for markets to move with one another,” said Mr Dimson, however adding that the argument still stands. The most compelling example of diversification was found to be within emerging markets, with the average correlation between individual markets only 0.55. Thus there is a case for diversifying well within these markets.

Higher growth does not imply higher stock returns, said the report, as prices tend to factor in expected growth, while growth also comes from the non-listed sector. In fact, stock markets tend to predict GDP growth. Therefore the outperformance of emerging market equities over the last ten years could be interpreted as pricing in their better growth prospects today.

“Emerging markets, though exciting, are not the only story in town,” said Mr Dimson, advising that investors should not forget developed markets, especially as the research found value investing outperformed growth investing over the long term.

As these markets have become more important, their GDP weightings (of world GDP) have increased dramatically. However the report shows that the market capitalisation story is very different, and while there’s a general consensus this will change, at the moment they cannot support a big reallocation of assets towards them, said Mr Dimson.

“We can’t invest by GDP [weightings] because there isn’t the market cap to go around in emerging markets,” he said.