Inefficiency=risk

Mutual fund investors are repeatedly told not to try to time the market, but such advice doesn’t work for the emerging market, where returns are subject to wide fluctuations.

Evidence shows that investors who use a buy-and-hold strategy in emerging markets are more likely to lose money or make smaller gains than market timers over the long term. In contrast, a buy-and-hold strategy works best in the more efficient developed markets.

For example, emerging market mutual funds available in Canada returned an average annual loss of 3.3% for the five-year period ended May 1999. This means a $10,000 investment would have been worth $8,531 after five years, a loss of $1,469. However, jumping in and out of the emerging market funds at the right time during the same period could have provided significant positive returns. If a $10,000 investment was made on March 1, 1995, it would have been worth $14,413 on August 1, 1997, for a total return of 44% or an annualized return of 16% over the 29-month period.

Investors would have lost the most money in the year ended August 1998, when emerging market funds made their biggest losses over the five-year period under review. This was largely because of the impact of the Asian meltdown. But since then, between Sept. 1, 1998, and May 31, 1999, emerging markets have yielded a 32% return over the nine-month period, meaning a $10,000 investment would be worth $13,232.

On the other hand, the average annual return for U.S. equity funds for the five years ended May 31 was 19.5%. A $10,000 investment here would have grown to $24,334.

Unlike emerging markets, returns in the more efficient U.S. market were relatively more stable. The average U.S. equity fund did not dip below a 5.5% return over the entire five-year period, while the emerging market funds’ one-year returns moved back and forth between negative and positive returns. In fact, the degree of volatility was almost double for the emerging market funds. The standard deviation of the average emerging market fund over the five-year period was 23%, compared with 12% for the average U.S. equity fund.

The accompanying chart, which uses rolling one-year returns over five years, helps to identify visually those one-year periods when an investment in the average emerging market fund would have been profitable. It also illustrates the wide range of returns common to emerging market funds, in contrast to the narrower U.S. range.

In developed markets there is a greater probability that the prices of securities in a fund are a true representation of underlying value. This leads to a lower probability of correction and lower overall volatility. However, if the mutual fund invests in less efficient, more volatile emerging markets there is a greater opportunity to gain, or lose, from market timing.

The expected higher volatility of emerging markets results from political and economic risks that are not as prevalent in developed markets.

Regardless of the skill and expertise of fund managers specializing in emerging markets, the funds are inescapably subject to a higher degree of risk than in developed markets. In emerging economies, the market effect is dominant. This means there is greater difficulty in diversifying away the unique risk of each security within a fund.

Emerging market mutual funds are also more volatile because they are inefficient. A market is considered efficient when prices quickly and accurately reflect new and existing information. An efficient market is characterized by high liquidity and low bid-ask spreads. Inefficient emerging markets are usually affected by political and economic instability, inadequate company disclosure and weak regulatory infrastructure.

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

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