If you've been keeping an eye on flows into mutual funds for the past few years, you may have observed a curious trend. Even though emerging-markets stock and bond funds have posted weak near-term returns, investors have been flocking to each category. That behavior runs counter to the one we typically observe, as investor dollars typically run away from--not toward--investment types with poor recent returns.
The first step if you're eyeing a position in emerging markets--contrarian or otherwise--is to gauge the extent to which your current holdings are already exposed to these areas. You can see your holdings' ratio of developed-/emerging-markets exposure by clicking on the "Portfolio" tab for individual mutual funds and exchange traded funds when visiting their Quote pages on Morningstar.com. The Markets Classification (% Emerging/% Developed) is toward the bottom of the Portfolio page.
Morningstar's X-Ray functionality doesn't currently depict developed/emerging stock exposure for your whole portfolio (but that's something we'll investigate as a future feature). For now, you could do a back-of-the-envelope calculation by totaling your portfolio's exposure to Latin America and Asia/Australia, but that's a rough view at best. Although Japan gets its own classification, Australia is a developed market, whereas Europe encompasses markets that are developing as well as developed.
To get a more precise read on your portfolio's developed/emerging exposure, you'd need to get out your calculator. Multiply each fund's emerging-markets exposure by that holding's percentage weighting in your equity portfolio, then total up those numbers for all of your holdings. To use a simple example, let's say you had two foreign-stock holdings: Harbor International (HAINX) and Vanguard Total International Stock Market Index (VGTSX), each of which constitutes 20% of your equity portfolio. The former has a 4.5% weighting in emerging markets, so it brings 0.9% of emerging markets to your equity portfolio (4.5 X .20 = 0.9). Vanguard Total International, meanwhile, has a 14.63% weighting in emerging markets, so it brings a roughly 3% weighting to your equity portfolio (14.63 X .20 = 2.93). The aggregate portfolio, then, has about 3.8% in emerging markets.
The next step is to gauge the reasonableness of that weighting. What follows are some benchmarks to help you assess your exposure. Note that the following discussion considers emerging markets in the context of country of domicile. But many developed-markets multinationals derive a significant share of their revenues from emerging markets. Thus, a company's classification as developed or developing is an imperfect guide to the extent to which its business is exposed to emerging markets.
The Laissez-Faire Approach
The simplest way to approach this topic is to look at the percentage of the globe's stock market value that emerging markets represent. Using Vanguard Total World Stock Market Index (VT) as a proxy for the global market cap, we can see that companies domiciled in emerging markets account for about 8% of the index; developed markets make up the rest. Thus, 8% of equities is a reasonable benchmark for investors who are taking a hands-off approach and aren't aiming to make active bets on or against emerging markets. It's a lofty weighting compared with what many asset-allocation experts recommend, however, as outlined below.
The Target-Date View
Target-date funds provide another perspective, showing how much professional asset allocators are steering toward emerging markets. In general, these funds tend to maintain more static weightings in emerging markets than is the case with Morningstar's Lifetime Allocation Indexes. The median emerging-markets weightings for funds geared toward investors retiring between 2045 and 2050 is 6% of equity; emerging markets consume 5% of the median 2026-30 fund as well as the median 2000-10 offering. All of these figures are lower than emerging markets' weighting as a percentage of global market capitalization, very likely because exposure to global multinationals provides additional indirect exposure with less volatility than companies domiciled in emerging markets.
Morningstar's two Gold-rated target-date series also generally maintain static weightings in emerging markets across life stage. For example, Vanguard's series holds 4% of its equity position in emerging markets across age bands. T. Rowe Price has a slightly higher weighting in emerging markets (6% of equities) for people retiring in 2050 and only slightly lower weightings (5% of equity assets) for the 2010 and 2030 age bands.
The Life-Stage Perspective
Morningstar's Lifetime Allocation Indexes, the broad outlines of which you can see here, argue for reducing one's emerging-markets weighting with life stage. The thinking is that younger investors can more readily tolerate emerging markets' excess volatility in exchange for potentially higher returns, but the volatility is hard to recover from as one nears and enters retirement.
For example, the emerging-markets weighting for people with moderate risk tolerances who anticipate retiring in 2050 is an even higher percentage than in the global market cap--roughly 10% of equities. But that figure dramatically declines as people near retirement. Emerging markets constitute 6.6% of the equity weighting for people retiring in 2030 and less than 4% of equities for people who retired in 2010. Broad foreign-stock weightings for all of the indexes follow a similar pattern, declining as the retirement date draws near.
