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

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 Bloomberg 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 Bloomberg Global High Yield Index