High economic growth rarely translates to superior stock market returns, making emerging markets a complex play of diversification and hidden risks.
The Growth Trap
One of the most persistent myths in investing is that economic growth and investment returns are positively related. It seems intuitive that investing in the fastest-growing economies would yield the highest returns, but historical data suggests the opposite. Research by Dimson, Marsh, and Staunton, as well as Jay Ritter, has documented a negative correlation between real per capita GDP growth and equity returns. In a study of 15 emerging markets from 1988 to 2011, Ritter found a correlation of negative 0.41. When an economy grows rapidly, the benefits are often spread across an increasing number of new shares as businesses raise capital to meet new demand. This dilution means that while aggregate earnings grow, earnings per share—the metric that actually drives stock prices—lags behind.
China serves as a stark modern example of this phenomenon. Despite decades of historic economic expansion, the Chinese stock market has delivered returns substantially lower than those of international developed markets. This is partly because high growth expectations are priced into the market early, leaving little room for upside, and partly because the process of economic recovery and expansion requires massive equity recapitalization. As seen in the post-war recoveries of the 20th century, the capital required to rebuild or expand an economy often comes at the expense of existing shareholders.
Market Integration and the Diversification Premium
If growth isn't the primary driver for investing in emerging markets, the argument shifts to diversification and the 'integration premium.' Emerging markets represent a massive physical and economic footprint—in terms of population and landmass—that is not fully reflected in financial indexes. This discrepancy exists because index providers use 'free float' weights, which exclude shares held by governments or company founders, and because many countries still impose restrictions on foreign ownership. Consequently, these markets are not fully integrated into the global financial system.
This lack of integration is actually a benefit for the portfolio builder. In a segregated market, assets are priced based on local risk factors rather than global ones, which typically leads to higher expected returns and lower correlations with developed markets. As a country liberalizes its financial markets and integrates with the world, its cost of capital falls and stock prices tend to rise. While this transition can provide a significant windfall for early investors, it is a one-time benefit. Over time, as integration increases, the diversification benefit tends to shrink as the market begins to move in lockstep with global trends.
The Reality of Disaster Risk
Investors often focus on volatility, but emerging markets carry a more specific statistical burden known as negative skewness, or 'disaster risk.' While most stock markets are somewhat negatively skewed—meaning they have infrequent but extreme crashes—emerging markets exhibit this trait more prominently. This is not just a theoretical concern; it is a historical reality. Between 1900 and 2020, emerging markets actually trailed developed markets, largely due to a catastrophic window between 1945 and 1949 when Japanese markets lost 97% of their value and Chinese markets closed entirely following the communist victory.
This 'left tail risk' is the reason emerging markets often command a risk premium. Investors require higher expected returns to compensate for the possibility of total loss or permanent capital impairment. We see this playing out in real-time with Russia’s recent demotion from 'emerging' to 'standalone' market status. Unlike standard volatility, which an investor can simply wait out, disaster risk involves political instability, the closing of exchanges, or the stripping of foreign investor rights. It is a reminder that the higher returns promised by emerging markets are a compensation for risks that can, and do, materialize.
The Friction of Costs and Taxes
Even when emerging markets perform well, the 'leakage' from fees and taxes can be substantial. Beyond slightly higher management fees, the primary culprit is foreign withholding tax. Many emerging market stocks have higher dividend yields, and the taxes withheld by the source country are often unrecoverable in registered accounts like a TFSA or RRSP. Furthermore, many Canadian-listed ETFs hold U.S.-listed versions of emerging market funds rather than the stocks directly. This creates a second layer of withholding tax that can drag down returns by as much as 0.7% annually.
These structural costs mean that the bar for emerging markets to outperform is higher than it appears on paper. An investor must decide if the expected risk premium is large enough to offset these guaranteed tax drags. While some funds attempt to mitigate this by holding securities directly, they often do so by excluding small-cap stocks, forcing the investor to choose between tax efficiency and the higher expected returns associated with smaller, more value-oriented companies.
A Balanced Allocation
Given the complexities of integration, disaster risk, and taxation, how should an investor approach this asset class? It is rarely sensible to use complex optimizers to find a 'perfect' percentage, as these models are highly sensitive to past data that may not repeat. Instead, a common-sense approach suggests that emerging markets deserve a place in a diversified portfolio, but perhaps not an aggressive overweight. Starting with free-float market capitalization weights—roughly 10% to 12% of a global portfolio—is a prudent baseline.
Investors must also be wary of the technical definitions used by index providers. For instance, MSCI classifies South Korea as an emerging market, while FTSE Russell considers it developed. Mixing products from different providers can lead to unintended gaps or overlaps in coverage. Ultimately, emerging markets provide a unique set of risk factors and premiums—such as value and profitability—that may show up when developed markets are stagnant. They are a vital tool for diversification, provided the investor understands that they are buying into a regime of high uncertainty and structural friction.