International markets continue valued at significant discounts to US markets. Of course, some of this is understandable given stronger domestic growth and volatile trade disputes. Emerging Market economies have traditionally been dependent on trade for GDP growth. However, many of these economies continue their maturation process and are today less dependent on exports than decades past. Additionally, central banks have learned to be less dependent on foreign currency financing ($, €, ¥ or £). As a result, foreign capital flows have less of an effect on a maturing EM economy. In a world awash with developed market central bank liquidity, we find it perplexing why capital hasn’t arbitraged away the EM valuation discount.
Academic financial theory posits that diversification can help maximize expected return per unit of standard deviation. Translation: a diversified portfolio can get similar returns with less risk than a concentrated portfolio. The Sharpe Ratio (developed by Nobel laureate William Sharpe) is defined by portfolio, or investment, excess return divided by the standard deviation of that return. Excess return is defined as the return of the portfolio/investment over the risk free return. In essence, how much excess return do you get per unit of risk. The higher the Sharpe Ratio, the better the quality of the portfolio/investment return, also known as the risk-adjusted return. The graphic below shows that adding EM to a US market portfolio has been able to improve returns while maintaining Sharpe Ratios. Portfolio risk is increased as you add EM, but the risk has been appropriately compensated by added portfolio returns.