Global Award

An Interesting Accolade for Dimensional's Emerging Markets Small Cap Fund

Global Award

A recent article in Bloomberg BusinessWeek about Dimensional Fund Advisors (DFA) Emerging Markets Small Cap Fund (DEMSX) caught our attention. The title, “Dimensional Winning in Emerging Markets: Riskless Return”, caused us to do the mother of all double-takes, as we would be the first people to tell you that there simply is no such thing as riskless return, and it certainly is not to be found in emerging markets. DEMSX is one of the three emerging markets funds used by IFA in the implementation of Index Portfolios. The article’s title is referring to the fact that when measuring the ratio of year-to-date return (as of 6/30/2014) divided by volatility, DEMSX scored the highest of all mutual funds measured, delivering 1.2% of return for each 1% of standard deviation.

Of course, six months of data should mean absolutely nothing to investors, so we looked at the 25-year period from 1/1/1989 (when the data on an emerging markets small cap index begins) to 12/31/2013, and we calculated the reward-to-risk ratio at 0.58 (13.9% annualized return divided by a 23.8% standard deviation), so the last six months should definitely be considered an anomaly, but we would guess that Dimensional Fund Advisors (DFA) would be happy to take it! We have yet to meet any investors with the intestinal fortitude to stomach that volatility to capture that 13.9% return with all of their investible funds. Such a fortunate soul would have grown a $10,000 investment to $259,000 over that 25 year period.

To understand how inapplicable the term “riskless” is to emerging markets, please review the drops shown below from peak-to-trough that occurred in the last 25 years:

While the last two of the three drops occurred during a global bear market where everyone was in the same sinking boat, the first drop occurred during a bull market period when the S&P 500 Index delivered a total return of 133.9%. This would have made it incredibly difficult to hold onto emerging markets small cap, unless it was limited to a small part of the overall portfolio.

Coincidentally, Dimensional’s research department recently issued an article1 on the continued viability of emerging markets as part of a globally diversified portfolio. This article appears to be a response to the fact that 2011 and 2013 were both difficult years for emerging markets compared to both international developed and U.S. markets, as shown below:

Of course, when the entire 26-year period for a direct emerging markets index is examined, the bigger picture emerges:

The fact that the above numbers look rather dismal for international developed is partly explained by the 1989 crash of the Japanese market, from which it has still not yet fully recovered. One interesting finding of the DFA researchers is that a good part of the return of emerging markets is explained by exposure to the risk of small cap companies. Thus, an emerging markets small cap fund should have a very high factor loading with respect to size.  An additional (but not quantified) risk of emerging markets is political risk—the uncertainty that a government can arbitrarily intervene in financial markets to the disadvantage of investors. For example, Venezuela under Hugo Chavez expropriated billions of dollars of assets owned by foreigners. The overriding theme of the DFA article is that country-picking or stock-picking among emerging markets can be extraordinarily risky, so the preferred approach to capturing the returns offered by emerging markets is through broadly-based funds with massive diversification. The three emerging markets funds recommended for implementing the IFA Index Portfolios hold a total of about 4,000 securities spread over 21 countries. The concluding sentence perfectly summarizes our view of emerging markets:

“Investors who have maintained a disciplined approach to investing in emerging markets and have been able to withstand the volatility of this asset class have been rewarded over the long term.”

To conclude, if emerging markets has a higher expected return than either U.S. or International Developed markets, then it is only because it carries higher risks. Risk and return are forever inseparable. 

1Ong, Daniel C., Rodriguez, L. Jacobo, Umland, and Umland, Karen. “Emerging Markets Doubts”, Dimensional Quarterly Institutional Review, First Quarter, 2014, pp. 4-9.