Emerging Markets Equity and Commodities – Remind me again, why?

February 17, 2016 Categories: Portfolio Corner
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Investors are coming off a difficult year as we enter 2016. In 2015, the U.S. equity market1 posted a meager +0.5% calendar-year return. Bonds2 matched that return at 0.5%. Almost every other asset class posted negative results. Non-U.S. equity,3 global REITs,4 global high yield,5 and global infrastructure6 were all down for the year. The worst offenders of late have been commodities and emerging markets equities. Not only were they double-digit negative in 2015 (the Russell Emerging Markets Index was down -12.8% and the Bloomberg Commodity Index was down -24.7), but these two asset classes have posted negative results over the last 5 years.

Annualized Returns

U.S. equity represented by the Russell 3000® Index, Emerging Markets Equity represented by the Russell Emerging Markets Index and Commodities represented by the Bloomberg Commodity Index.

So, it’s perhaps no surprise that the value of these diversifiers – commodities and emerging market equities in particular – is under scrutiny by many investors. Negative returns for one year gets many investors’ attention; negative returns for 5 years gets investors wondering why the allocation wasn’t nixed two years ago.

What can you say to help assuage clients who want a justification for keeping these two as part of their overall portfolio? Consider the following:

The portfolio role of emerging markets equity and commodities

Often, it can help to start at the beginning. Why did these asset classes make it into the portfolio to begin with?

The primary driver for adding diversifiers to a portfolio of U.S. stocks and bonds is typically because they have historically performed differently from U.S. stocks and bonds. As we have just experienced, both emerging markets and commodities check that box.

Beyond the different performance pattern, each has a separate primary role to play.

  • Emerging markets are typically included in a portfolio to increase the overall return potential of the portfolio. Based on Russell Investments’ Capital Market Projections, emerging markets equities have the highest long-term return expectation on a 20-year time frame. This is based on a number of factors, but higher Russell-projected long-term economic growth from these markets is a significant factor.
  • Commodities are included primarily for their historically unique return pattern from stocks and bonds, and thus their potential volatility-lowering impact on the overall portfolio. According to our Capital Market Projections, commodities are expected to deliver long-term returns between stocks and bonds, varying based on conditions.

So, there were solid reasons for adding these asset classes to portfolios – and to a certain extent emerging markets and commodities have fulfilled their diversifying role. Of course, that’s not entirely satisfying to most concerned investors, so let’s continue.

Should investor expect improvement in the future?

The short answer is “likely,” but patience will be necessary. History has shown that following difficult (negative) stretches, these two asset classes tend to rebound with solid to strong numbers.

Emerging Markets represented by the Russell Emerging Markets Index. Commodities represented by the Bloomberg Commodity Index.

Emerging Markets represented by the Russell Emerging Markets Index. Commodities represented by the Bloomberg Commodity Index.

Of course, investors need to bear in mind that both asset classes are likely to deliver high levels of volatility for the foreseeable future, as global growth remains choppy and oil prices try to find a bottom. However, long-term, current attractive valuations for emerging markets equities, and low energy prices suggest these two assets classes may have room to move up in price over time, rewarding patient diversified investors with appropriate risk tolerance levels.

The bottom line

It can be very difficult to stick with an investment that “hasn’t been working.” Unfortunately, disappointing results from the past five years would suggest that emerging markets equity and commodities fit that category. However, before abandoning any investment it’s best to revisit the original reason for holding it and assess its potential future impact on the portfolio. In the case of emerging markets and commodities, we believe that both have the potential to deliver on long-term objectives for investors with commensurate risk tolerance. Emerging markets are still positioned to potentially deliver among the highest returns in a diversified portfolio and commodities are likely to continue to deliver a unique return pattern relative to stocks and bonds.

1 Represented by the Russell 3000® Index

2 Represented by the Barclays Aggregate Bond Index

3 Represented by Russell Developed ex-U.S. Large Cap Index

4 Represented by FTSE EPRA/NAREIT Developed Real Estate Index

5 Represented by S&P Global Infrastructure Index

6 Represented by Barclays Global High Yield Index

The Barclays Global High-Yield Index provides a broad-based measure of the global high-yield fixed income markets. The Global High-Yield Index represents that union of the U.S. High-Yield, Pan-European High-Yield, U.S. Emerging Markets High-Yield, CMBS High-Yield, and Pan-European Emerging Markets High-Yield Indices.

Barclays U.S. Aggregate Bond Index is an index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities.

Bloomberg Commodity Index: Composed of futures contracts on physical commodities. Unlike equities, which typically entitle the holder to a continuing stake in a corporation, commodity futures contracts normally specify a certain date for the delivery of the underlying physical commodity. In order to avoid the delivery process and maintain a long futures position, nearby contracts must be sold and contracts that have not yet reached the delivery period must be purchased. This process is known as “rolling” a futures position.

FTSE EPRA/NAREIT Developed Real Estate Index is a global market capitalization weighted index composed of listed real estate securities in the North American, European and Asian real estate markets.

The Russell 3000® Index: Measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.

The Russell Emerging Markets Index measures the performance of the largest investable securities in emerging countries globally, based on market capitalization. The index covers 21% of the investable global market.

The S&P Global Infrastructure Index provides liquid and tradable exposure to 75 companies from around the world that represent the listed infrastructure universe. To create diversified exposure across the global listed infrastructure market, the index has balanced weights across three distinct infrastructure clusters: Utilities, Transportation, and Energy.
Strategic asset allocation and diversification do not assure profit or protect against loss in declining markets.The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

Exposure to the commodities markets may subject the investment to greater volatility than investments in traditional securities, particularly if the investments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or sectors affecting a particular industry or commodity and international economic, political and regulatory developments. The use of leveraged commodity-linked derivatives creates an opportunity for increased return, but also creates the possibility for a greater loss.

Investments in emerging or developing markets involve exposure to economic structures that are generally less diverse and mature, and to political systems which can be expected to have less stability than those of more developed countries. Securities may be less liquid and more volatile than US and longer-established non-US markets.

Strategic asset allocation and diversification do not assure profit or protect against loss in declining markets.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Indexes are unmanaged and cannot be invested in directly.

Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide, including Russell Financial Services, Inc., member FINRA. Russell Investments is part of London Stock Exchange Group.

Copyright © Russell Investments 2016. All rights reserved.

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

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