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Photo: Reuters
Photo: Reuters

Frontier and emerging markets: What’s behind the lower long-term returns

  • Much of it is due to exchange-rate risk for U.S.-based investors

Investors looking to boost returns over the long run often turn to emerging-markets mutual funds and even frontier-markets funds, with the idea that the more risk you take, the greater the long-run returns.

But my look at the data for this sector shows that more often than not, the riskier the country’s stocks, the lower the long-run returns.

And in most cases, the underlying reason for this mismatch in the risk-reward relationship is something that’s difficult for most investors to properly hedge against in their portfolios—the decline in the value of a particular emerging market’s currency relative to the U.S. dollar.

I examined the returns and volatility of mutual funds and ETFs in emerging-markets and frontier-markets countries where at least 20 funds are listed that focus on that particular country and are priced in dollars. This captures most countries investors consider to be emerging or frontier markets (Brazil, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Taiwan, Thailand, Turkey, Vietnam) but doesn’t include Argentina, Malaysia and Pakistan.

Taiwan, Thailand are tops

Over the past 10 years, the two countries with the best performance of funds specific to them were Taiwan and Thailand, with annualized returns of 9.1% and 6.7%, respectively. These two countries also had some of the lowest volatility in their funds’ returns over this 10-year period, at 17.3% volatility for Taiwan and 19.9% for Thailand.

On the other end of the spectrum were Turkey and Brazil. These two countries averaged annualized returns of minus 5.5% and minus 5.1%, respectively, over the past 10 years. And these markets were especially risky. Turkish and Brazilian funds averaged 10-year volatility of 31.4% and 29.8%, respectively.

Overall, in these far-reaching parts of the world, even the top-performing countries couldn’t match the performance of U.S. stocks. Over the past 10 years the S&P 500 averaged greater returns (15.1% annualized) and lower volatility (13.8%) than any emerging or frontier market. Whether this continues is to be seen.

Currency risk

Now, what can help explain the relatively poor returns in the riskiest areas of the global economy? Much of the blame goes to the underlying currency risk, or exchange-rate risk, for U.S.-based investors in frontier- and emerging-markets funds.

Since most companies operating in a particular country have a good portion of their earnings coming to them in their local currency, this leaves any U.S.-dollar-based fund investing in them exposed to fluctuations in the local exchange rate. If a local currency should lose a lot of its value, then the dollar-based fund investing in that country will fall in value as well (aside from the few ETF and mutual-fund products that actively hedge the local currency).

To highlight this risk, over the past 10 years, the Turkish lira lost more than 75% of its value against the U.S. dollar (falling from 65 cents to the lira in 2010 to 14 cents currently). The Brazilian real lost more than 60% of its value against the dollar (falling from 55 cents to the real in 2010 to 20 cents currently). Conversely, for the two best-performing emerging or frontier markets, the New Taiwan dollar and the Thai baht both slightly gained in value against the U.S. dollar over the past 10 years.

For most investors this is a difficult problem to adjust for in their portfolio. Some can buy a currency-hedged stock fund—but often no such fund exists for these countries. In that case, an investor would need to hedge the stock fund by also purchasing a currency fund that moves with the dollar’s fluctuations against the currency in question. Sometimes, again, no such fund exists. But even when one does, buying the currency fund in the correct proportion to cancel out the currency risk of the stock fund is difficult, involving extensive research and analysis of how the two fund’s movements are correlated.

Dr. Horstmeyer is an associate professor of finance at George Mason University’s Business School in Fairfax, Va. He can be reached at reports@wsj.com.

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