Why emerging markets are essential to any equity portfolio

Adapted from the article ‘World-beating investment returns: Emerging markets win over two decades’ by Srinivasan Sivabalan, Bloomberg
 
 If you want superior returns, including emerging markets in your portfolio is essential
According to data from Bloomberg, the top 10 stock indexes that delivered the best returns in 2016 were all emerging or frontier markets. What’s more, over the past 20 years, 9 out of 10 best-performing equity gaugegs have been in developing nations. This indicates that including emerging markets in your portfolio – or your clients’ portfolios – is essential if you want superior returns from your equity investments year after year.
The data proves many of the preconceptions that investors have about emerging markets wrong
The general perception is that emerging markets are riskier because their higher returns come with greater market and currency volatility. However, if we take a closer look at the data, the flaws in these perceptions are evident. Certain data sets show that investors make more money in emerging and frontier markets on a volatility risk-adjusted basis.
The table shows that emerging markets dominate the positions as top stock markets, even when the gains are converted into US dollars. Brazil was the best equity market in dollar terms in 2016, with its benchmark index gaining 69%. When we consider volatility-adjusted returns, Kazakhstan came out on top. Pakistan (which will formally upgrade to an emerging market from a frontier nation at MSCI this year) came in second. The last time wealthy nations dominated the list of equity gainers was in 1998, when emerging markets were shaken by the Russian debt default and the aftermath of the Asian currency crisis. That year, the number one market in dollar terms was Greece, which was downgraded to an emerging market by MSCI in 2013.
Top 10 stock markets in US dollar terms (1999-2016)*

Source: Bloomberg
The stellar performance, however, does not mean that every emerging market is a top performer
Although the data provides clear evidence that emerging markets rightfully deserve a position in top equity portfolios, it is crucial to interpret the data correctly. The data shows that most top-performing stock markets are emerging nations; it does not claim to state that every emerging market is a top performer. In fact, the data also shows that the developing world dominates the list of markets that have made the biggest losses.
A carefully selected portfolio of emerging markets offers the potential of rewarding returns
The MSCI Emerging Markets Index trades at 12.1 times the projected earnings of its members, 26% lower than the price-earnings ratio for the MSCI World Index. According to Julian Mayo, Co-Chief Investment Officer at Charlemagne Capital Ltd in London, there are sufficient indicators that emerging markets may continue their winning run in 2017. Mayo believes developing nations will benefit from higher earnings expectations, expanding growth differentials with wealthy nations, and more disciplined capital spending by companies. If Mayo is right, a careful selection of investments with emerging market exposure may provide superior returns this year.