For many investors, the S&P 500 represents the epitome of a reliable and rewarding investment. This index has consistently delivered strong returns and has become a cornerstone of most investment portfolios.

However, relying solely on the S&P 500 can create a false sense of security and limit potential growth opportunities.

To truly optimize long-term investment success, diversification beyond what feels comfortable at the moment is crucial.

One compelling option for diversification is emerging market equities. These markets offer significant growth potential, attractive valuations, and the added benefit of low correlation with U.S. equities.

In an era where U.S. markets are experiencing high valuations, now is an opportune time to explore the undervalued and underperforming assets in emerging markets.

By stepping out of the comfort zone of the S&P 500 and into the dynamic world of emerging market equities, investors can position themselves for future gains and enhanced portfolio resilience.

Higher Economic Growth Potential in Emerging Markets

Emerging markets have long been recognized for their potential to deliver higher economic growth compared to developed markets.

This growth is driven by several factors, including favorable demographics, increasing urbanization, and expanding middle classes. For example, countries like India, Brazil, and Indonesia are experiencing rapid economic expansion, fueled by a young and growing workforce and rising consumer demand.

The IMF expects emerging market growth this year as well as next to be more than double that of developed economies.

India, a large weight in the MSCI Emerging Market Index, stands out with its robust economic trajectory. As the world's largest democracy, India has implemented numerous reforms aimed at enhancing its business environment and attracting foreign investment. The country's large and youthful population is a significant asset, ensuring a steady supply of labor and a burgeoning consumer base. India's GDP growth rate has consistently outpaced that of many developed economies, making it an attractive destination for investors seeking growth.

According to the International Monetary Fund (IMF), emerging and developing economies are projected to grow at nearly twice the rate of advanced economies over the next decade.

This growth translates into higher corporate earnings and, consequently, the potential for superior stock returns in the long term.

Investing in emerging market equities allows investors to tap into this growth potential. By allocating a portion of their portfolios to these markets, investors can benefit from the economic dynamism and demographic advantages that emerging economies offer.

While emerging markets come with their own set of risks, such as political instability and currency volatility, the growth opportunities they present can make them a valuable addition to a diversified investment strategy.

Attractive Valuations and Underperformance

One of the most compelling reasons to consider emerging market equities is their attractive valuations compared to developed market counterparts, particularly the S&P 500.

Over the past decade, emerging markets have significantly underperformed U.S. equities, leading to a considerable valuation gap that savvy investors can exploit.

As of recent data, the price-to-earnings (P/E) ratios of many emerging market indices are significantly lower than those of the S&P 500. For example, the MSCI Emerging Markets Index, which includes a broad range of stocks from developing economies, trades at a substantial discount to the S&P 500.

As of the end of April, the P/E of the MSCI Emerging Market Index stood at 15 compared to a P/E of 26 for the S&P 500. The price-to-book, another popular valuation metric was similarly magnitudes higher than that of the emerging market index.

The historical underperformance of emerging market equities relative to U.S. equities has created a scenario where these markets are now undervalued. 

This underperformance can be attributed to several factors, including economic slowdowns, political instability, and recent global events such as the COVID-19 pandemic, which hit emerging markets particularly hard. However, these challenges also mean that these markets have significant room for growth and recovery, providing a unique opportunity for investors.

China, which constitutes about one-third of the MSCI Emerging Markets Index, plays a pivotal role in this narrative. Despite recent economic slowdowns and regulatory crackdowns, China's long-term growth prospects remain strong. The Chinese government has introduced measures to stabilize its financial markets and stimulate economic growth, including significant investments in infrastructure and technology.

The attractive valuations and historical underperformance of emerging market equities present a compelling case for investors looking to diversify away from the S&P 500.

By capitalizing on these undervalued assets, investors can position themselves to benefit from potential catch-up growth in emerging markets, particularly as global economic conditions post-COVID improve.

Diversification Benefits and Lower Correlation

Diversification is a fundamental principle of investing, aimed at reducing risk by spreading investments across various asset classes, sectors, and geographies. Emerging market equities play a crucial role in this strategy by offering diversification benefits that are not typically found in U.S. equities alone.

One of the key advantages of investing in emerging market equities is their lower correlation with U.S. equities.

Correlation measures the degree to which two asset classes move in relation to each other. A lower correlation means that the performance of one asset class does not closely mirror the performance of another.

Historically, emerging market equities have demonstrated a lower correlation with U.S. equities, which can help mitigate portfolio volatility. Correlations are, of course, ever-changing but at the moment the correlation between US equities and those of emerging markets stands at roughly 0.7 providing attractive diversification benefits to a multi-asset class portfolio.

For example, during periods when the U.S. equity market experiences downturns, emerging markets may not be affected to the same extent, or they may even perform better. This divergence in performance can provide a buffer against losses in a portfolio that is heavily weighted towards U.S. stocks. By including emerging market equities, investors can achieve a more balanced and resilient portfolio.

In addition to lower correlation, the economic drivers in emerging markets often differ from those in developed markets. While the U.S. economy may be influenced by factors such as Federal Reserve policies, corporate earnings reports, and domestic consumption patterns, emerging markets are driven by a different set of dynamics. These include rapid urbanization, infrastructure development, and increasing consumer demand from a growing middle class.

Moreover, the current high valuations in U.S. equity markets further underscore the need for diversification. As U.S. stocks have surged to record highs, the potential for a correction increases. In contrast, many emerging markets have not kept pace with this growth and remain undervalued. This discrepancy offers a strategic entry point for investors looking to diversify their holdings and capitalize on the growth potential of these markets.

The diversification benefits and lower correlation of emerging market equities with US equities make them a valuable addition to any investment portfolio.

By spreading investments across different economic cycles and growth drivers, investors can reduce risk and enhance long-term returns. This strategic approach is especially pertinent in the current environment of high U.S. market valuations, where looking beyond the comfort zone of the S&P 500 can yield significant advantages.

Preferred Emerging Market Equity Funds

When it comes to investing in emerging market equities, selecting the right funds is crucial. At Retirement Juice, we typically advocate for low-cost index funds to acquire exposure.

Here are five highly recommended exchange-traded funds (ETFs) that provide diversified exposure to emerging markets: IEMG, VWO, SPEM, and SCHE.

iShares Core MSCI Emerging Markets ETF (IEMG)

• Expense Ratio: 0.11%

• Holdings: Over 2,400 stocks

• AUM (Assets Under Management): $83 billion

Key Features:

Broad Exposure: IEMG offers broad exposure to a wide range of emerging market equities, with a substantial number of holdings.

Low Cost: With an expense ratio of 0.11%, it is one of the most cost-effective options for investors seeking diversified exposure to emerging markets.

Diversification: The fund covers large, mid, and small-cap stocks, providing extensive diversification.

Vanguard FTSE Emerging Markets ETF (VWO)

• Expense Ratio: 0.10%

• Holdings: Over 4,000 stocks

• AUM (Assets Under Management): $73 billion

Key Features:

Extensive Holdings: VWO offers one of the most extensive coverages of emerging market equities, with a very high number of holdings.

Low Expense Ratio: With an expense ratio of 0.10%, VWO is the most cost-effective option among the listed funds.

Diversification: The fund includes a broad mix of large, mid, and small-cap stocks, providing comprehensive market exposure.

SPDR Portfolio Emerging Markets ETF (SPEM)

• Expense Ratio: 0.11%

• Holdings: Over 1,900 stocks

• AUM (Assets Under Management): $10 billion

Key Features:

Cost-Effective: Similar to IEMG, SPEM offers a low expense ratio of 0.11%, making it a cost-efficient choice.

Broad Exposure: The fund provides broad exposure to emerging markets, with a significant number of holdings.

Mid-Sized Fund: SPEM is smaller in terms of AUM compared to IEMG and VWO but still offers substantial market coverage.

Schwab Emerging Markets Equity ETF (SCHE)

• Expense Ratio: 0.11%

• Holdings: Over 1,700 stocks

• AUM (Assets Under Management): $9 billion

Key Features:

Low Cost: SCHE's expense ratio of 0.11% makes it a competitive choice for cost-conscious investors.

Diverse Holdings: The fund provides exposure to a diverse range of emerging market equities, with a significant number of holdings.

Smaller AUM: While SCHE has a smaller AUM compared to some of the larger funds like IEMG and VWO, it still offers substantial diversification.

Comfort often equates to familiarity, and for many U.S. investors, the S&P 500 is the epitome of that comfort zone.

However, true investment success often requires stepping out of this comfort zone and exploring opportunities that may initially seem unfamiliar or even uncomfortable.

Emerging market equities, with their higher growth potential, attractive valuations, and diversification benefits, present a compelling case for doing just that.

Investing in emerging market equities means embracing the dynamic and often volatile nature of these markets. Yet, it is precisely this volatility and underperformance relative to the U.S. markets that create significant opportunities for astute investors.

True investment success often lies in the willingness to explore new frontiers and seize opportunities that others may overlook.

Emerging market equities represent such an opportunity - one that can significantly contribute to achieving your long-term financial goals.

Asset Allocation Performance Review

High-Level Observations:

• All asset allocation portfolios we monitor are up year-to-date with higher-risk portfolios exhibiting commensurate higher returns.

• Conservative portfolios with a heavier allocation to bonds are still recovering from the rise in interest rates starting in 2022.

• Over the last three years, the GF Low-Risk strategy is only up 1.6% on an annualized basis (before fees and transaction costs). Going back 5 years the annualized performance improves to 5%.

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities.

• The GF High-Risk strategy is up 3.8% on an annualized pre-cost basis over the last three years. Over the last 5 years, the strategy is up a respectable 8.3%.

• Year to date, commodities have provided a nice boost. A big reason is higher oil prices. Most recently, precious metal prices have joined the party providing a further boost.

• International fixed income remains a disappointing asset class for IUS investors. Yields are lower than in the US and the unexpected strength of the US dollar has resulted in negative performance.

• Over the last month, Emerging Market Equities have performed best in large part driven by the resurgence of the Chinese equity market.

• Fixed-income strategies focused on short maturities and credit have outperformed Treasuries.

Weekly Performance Attribution

Long-Term Asset Allocation Portfolio Characteristics

Expected Returns: Expect slightly lower than normal equity and bond market returns given valuation conditions

Risk: Diversify with alternative assets, market volatility has been significantly below historical measures

Equity Risk: Asset allocation portfolios are dominated by equity market risk, no different from the past.

A Bit of Wisdom Never Hurts

Disclaimer: This newsletter is not trading or investment advice but for general informational purposes only. This newsletter represents my personal opinions which I am sharing publicly as my blog. Futures, stocks, and bonds trading of any kind involve a lot of risk. No guarantee of any profit whatsoever is made. You may lose everything you have. We guarantee no profit whatsoever, You assume the entire cost and risk of any trading or investing activities you choose to undertake. You are solely responsible for making your own investment decisions. Owners/authors of this newsletter, its representatives, its principals, its moderators, and its members, are NOT registered as securities broker-dealers or investment advisors either with the U.S. Securities and Exchange Commission, CFTC, or with any other securities/regulatory authority. Consult with a registered investment advisor, broker-dealer, and/or financial advisor. By reading and using this newsletter or any of my publications, you are agreeing to these terms. Any screenshots used here are the courtesy of Global Focus Capital and Retirement With Possibilities. The data, quotes, and information used in this blog are from publicly available sources and could be outdated or outright wrong - I do not guarantee the accuracy of this information.