Should you buy the upstarts?

Whether emerging markets are outperforming developed markets or lagging behind them, a key argument for buying them rarely changes: developing economies grow faster than their Western counterparts.

That implies faster profit growth and, investors hope, higher returns than in developed markets. But is this really true?

This year's annual Global Investment Returns Yearbook by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, published by Credit Suisse, takes a detailed look at emerging markets' long-term performance by constructing an index of them going back to 1900.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Many investors will be surprised to find that, over the past 114 years, emerging markets have underperformed advanced-country markets. The latter have returned an annual average of 8.3%, compared to emerging markets' 7.4%.

There have been long periods when emerging markets have done much better, most recently in 2000-2010. Overall, from 1950 to 2013 they achieved an annualised return of 12.5%, versus 10.8% from developed markets. But there were also times when performance was hit by catastrophic events, such as war or revolution.

Investors in Russia in 1917 and China in 1949 lost everything when the markets were shut down and assets seized by the state.

It's also notable that markets in the countries with the fastest growth rates don't produce the best returns; in fact, the opposite is true. Investing in markets with the highest growth in the past five years would have delivered 14% a year since 1972 in dollar terms. Betting on those with the lowest growth would have produced 28%.

Why is this? The key reason is the value effect. Stocks in fast-growing countries get bid up in price and as they become more expensive there is less scope for future outperformance. Conversely, the markets in states where growth has been weak are cheaper, making it easier for them to deliver strong returns.

The report tested this by dividing emerging markets into groups based on dividend yield. From 1976 to 2013, the quintile with the highest yielders easily outpaced the lowest yielders, returning 31% a year and 10% respectively.

So, the key lesson for emerging-market investors is the same as it is for all investors: avoid the fashionable stars being touted by investment managers and buy cheap.