Emerging markets have failed to live up (says M* article)

[nisiprius]

...Is China really an emerging market/economy?...

According to Wikipedia, ten out of ten authorities think so, including the IMF, FTSE, MSCI, S&P, Dow Jones, and Russell.

[Elysium]

You're missing the fact that there are plenty of risky strategies with low returns. Most stocks underperform t-bills.

The Chinese "stocks" you are buying are actually VIEs. When you buy BABA or 9988, you are buying shares in a Cayman Islands shell company that has contracts with the real Alibaba.

.....

The reasons Chinese companies do this is because the government does not want foreigners to own companies in certain industries. If you want to learn more about it, look up their foreign investment negative list (FINL). Personally, I think it's a bad idea to use Cayman Island shell companies to bypass the Chinese government's foreign investment regulations.

So you're arguing investors in EM should actively manage their country allocations? What are the rules for picking some and avoiding others?

Don't think that's something anyone can pull off, either you invest in the whole basket or you don't, actively managing country allocations is a job best left to traders.

That said, you may have hit the point on why EM may be a losing proposition (or at the minimum not suitable to long term passive buy & hold) with the highlighted text [OT comment removed by admin LadyGeek]. It is likely that the higher expected returns of EM stays "expected" but not realized returns. This could be due to a negative premium for EM stocks, some of which are due to the issues pointed out by the author. It is like investing in Junk Bonds, you expect a certain amount of default, and in order to get compensated for the loss from default you need the yield spread to be substantially higher. EM stocks are like junk bonds on steroids, therefore the expected returns have to be substantially higher even to consider investing in them, meaning the valuation spreads have to be very high, and only in such times it makes sense investing in them. Sounds like another active management decision is needed, and combined with needing to exclude some countries vs others, etc, a lot of active decisions which could just end up being costly with unpredictable results.

[000]

Except..... all those times the EM return was realized. And all those future risks of other geographies you don't yet know about.

Why do some Bogleheads cling to the belief that they can pick geographies?

[Robot Monster]

Why do some Bogleheads cling to the belief that they can pick geographies?

Ahhh...seems Bogle himself was a geography picker!

Bogle: “The three largest countries in the international index [EAFE] are Great Britain, Japan and France, and to bet those countries will do better than the U.S. in the long run is a bad bet.”

[hillclimber]

[Quoted post and OT comments removed by admin LadyGeek]

What are the rules for picking some and avoiding others?

Obviously, the "rule" is to avoid VIEs because they aren't stocks. [OT comments removed by admin LadyGeek]

There isn't a law of the universe that states that emerging markets have higher returns. Whenever you say "expected returns," you're implicitly bringing in a boatload of assumptions into the discussion. Emerging market stocks could be like high beta lottery ticket stocks. They might have periods of outperformance, but they could underperform longer term. Maybe they have similar returns long term. Their performance prior to the 2010's may have been the outlier. In that case, they would offer some diversification benefit, but it might not be enough to justify the portfolio complexity and higher expense ratios of emerging market funds.

So you're arguing investors in EM should actively manage their country allocations? What are the rules for picking some and avoiding others?

I'm not actively managing my country allocations. I checked my asset allocation and saw that my allocation for sketchy Cayman Island VIEs was set to 0%. I guess you could invest in VIEs as a form of "alternatives," if you wanted to.

If you think that this is some oddity, then you don't understand how "passive" investing works. Index providers like MSCI have criteria for countries to include. Look up the market accessibility criteria, and you'll see stuff like "openness to foreign ownership" as one of them.

[Nathan Drake]

[Quoted post and OT comments removed by admin LadyGeek]

What are the rules for picking some and avoiding others?

Obviously, the "rule" is to avoid VIEs because they aren't stocks. [OT comments removed by admin LadyGeek]

There isn't a law of the universe that states that emerging markets have higher returns. Whenever you say "expected returns," you're implicitly bringing in a boatload of assumptions into the discussion. Emerging market stocks could be like high beta lottery ticket stocks. They might have periods of outperformance, but they could underperform longer term. Maybe they have similar returns long term. Their performance prior to the 2010's may have been the outlier. In that case, they would offer some diversification benefit, but it might not be enough to justify the portfolio complexity and higher expense ratios of emerging market funds.

So you're arguing investors in EM should actively manage their country allocations? What are the rules for picking some and avoiding others?

I'm not actively managing my country allocations. I checked my asset allocation and saw that my allocation for sketchy Cayman Island VIEs was set to 0%. I guess you could invest in VIEs as a form of "alternatives," if you wanted to.

If you think that this is some oddity, then you don't understand how "passive" investing works. Index providers like MSCI have criteria for countries to include. Look up the market accessibility criteria, and you'll see stuff like "openness to foreign ownership" as one of them.

There are fundamental reasons why you should expect higher returns. The discount rate is higher. Higher valuations = less risk = less expected returns. The market has priced in the risk for EM, so over long periods investors are demanding a higher potential payout for taking on such risk.

The same arguments you are making about EM could be stated of any market, including the US

[hillclimber]

There are fundamental reasons why

I agree. However, there are also fundamental reasons why not. investing theory = backtest + story

The same arguments you are making about EM could be stated of any market, including the US

Well, yeah, that's the point. I think that there's a good chance that, long term, most countries have similar performance. I'm not the one arguing that emerging markets have a premium.

[watchnerd]

If you have a market weight global portfolio, EM is less than 10% of your equities. Since that portfolio is absolute nuts to many around here (too much ex-US!),

I'm part of the absolute nutso crowd.

Other than trying to hold market weight in EM, I don't even know how much that is without looking it up.

VT is VT.

[Nathan Drake]

There are fundamental reasons why

I agree. However, there are also fundamental reasons why not. investing theory = backtest + story

The same arguments you are making about EM could be stated of any market, including the US

Well, yeah, that's the point. I think that there's a good chance that, long term, most countries have similar performance. I'm not the one arguing that emerging markets have a premium.

There are no “fundamental” reasons why not, unless valuations were higher in EM which they sometimes can be. EM was seen as less risky prior to 2008, and was priced accordingly

Low valuations, higher expected growth = higher expected returns, with more risk

[hillclimber]

There are no “fundamental” reasons why not, unless valuations were higher in EM which they sometimes can be. EM was seen as less risky prior to 2008, and was priced accordingly

Low valuations, higher expected growth = higher expected returns, with more risk

That's a cool story. I've heard it many times, but I guess it never gets old.
I might be more willing to believe it if most stocks didn't underperform t-bills.

[LadyGeek]

I removed some off-topic comments. As a reminder, see: General Etiquette

We expect this forum to be a place where people can feel comfortable asking questions and where debates and discussions are conducted in civil tones.

...At all times we must conduct ourselves in a respectful manner to other posters. Attacks on individuals, insults, name calling, trolling, baiting or other attempts to sow dissension are not acceptable.

[Elysium]

Obviously, the "rule" is to avoid VIEs because they aren't stocks. [OT comments removed by admin LadyGeek]
...
I'm not actively managing my country allocations. I checked my asset allocation and saw that my allocation for sketchy Cayman Island VIEs was set to 0%. I guess you could invest in VIEs as a form of "alternatives," if you wanted to.

An active decision. How am I supposed to do that when I don't know what a VIE is in the first place as a passive investor. The BH passive investing doesn't require an investor scouring the internet and fund SAI to figure out what components are good or bad. The idea is to hold the market, do not time the market, and get the compounded returns at lowest cost possible. A passive investor don't know and don't care what VIEs are and don't wish to indulge in active analysis.

There isn't a law of the universe that states that emerging markets have higher returns. Whenever you say "expected returns," you're implicitly bringing in a boatload of assumptions into the discussion. Emerging market stocks could be like high beta lottery ticket stocks. They might have periods of outperformance, but they could underperform longer term. Maybe they have similar returns long term. Their performance prior to the 2010's may have been the outlier. In that case, they would offer some diversification benefit, but it might not be enough to justify the portfolio complexity and higher expense ratios of emerging market funds.

You made my point, there is a lottery effect, and a negative premium. Again, active investors or traders may try their luck, however, it doesn't sound like passive investors should overweight. EM is perhaps like holding Commodities, there is a negative premium, and long stretches of underperformance followed by short bursts of outperformance. That makes it a poor choice except when used as part of a broad Total Intl Index. The author made the argument this is best left to active management, and BH would say this should be best left as part of a broad international index.

If you think that this is some oddity, then you don't understand how "passive" investing works. Index providers like MSCI have criteria for countries to include. Look up the market accessibility criteria, and you'll see stuff like "openness to foreign ownership" as one of them.

I am comfortable with index methodology used by large providers as MSCI, S&P, etc. No need to second guess on top of that what else I should actively avoid by looking up whether something is in Cayman islands or Madagascar.

For the record, I am not against folks making active decisions, to overweight EM or any other asset, exclude countries or not, look at valuations to determine allocations, on and on.. but their success rate is not very high. Some wish to exclude things, some like to include them. The market is made of all those noises. The sum of it is what the index produces, be right or wrong. It isn't impossible to devise a strategy that outperforms a simple passive buy & hold portfolio, with a lot of time spent on doing research, fiddling with allocations, trial & error, etc. But the success rate of those over long periods are minimal, and even when you win it's by a tiny margin that really do not make a difference. Then the chance of failure is also very high, most people end up underperforming.

[hillclimber]

I am comfortable with index methodology used by large providers as MSCI, S&P, etc. No need to second guess on top of that what else I should actively avoid by looking up whether something is in Cayman islands or Madagascar.

I became less comfortable with these companies after learning this stuff. Including VIEs in a stock fund is like mixing sawdust in with flour. It's funny you mention S&P. They helped cause the 08 recession by rating garbage mortgage backed securities as investment grade. They haven't changed.

https://www.wsj.com/articles/how-china- ... 1549195201
Basically, China's stock exchanges threatened to cut MSCI's access to market pricing data in order to pressure them to include more of their stocks, even though they scored poorly on MSCI's investability metrics.

You keep saying "active" this "active" that. I'm being less "active" than MSCI. They "actively" included more Chinese stocks after being pressured by stock exchanges.

[Elysium]

I am comfortable with index methodology used by large providers as MSCI, S&P, etc. No need to second guess on top of that what else I should actively avoid by looking up whether something is in Cayman islands or Madagascar.

I became less comfortable with these companies after learning this stuff. Including VIEs in a stock fund is like mixing sawdust in with flour. It's funny you mention S&P. They helped cause the 08 recession by rating garbage mortgage backed securities as investment grade. They haven't changed.

https://www.wsj.com/articles/how-china- ... 1549195201
Basically, China's stock exchanges threatened to cut MSCI's access to market pricing data in order to pressure them to include more of their stocks, even though they scored poorly on MSCI's investability metrics.

You keep saying "active" this "active" that. I'm being less "active" than MSCI. They "actively" included more Chinese stocks after being pressured by stock exchanges.

You have a lot of opinions, I understand, many people do, that is called making active decisions based on subjective parameters. Based on evidence something that has negative impact on one's long term investing success. Fine, but it's your choice, that's not the question here. You did not answer how a passive buy & hold investor is supposed to know what is a VIE, whether it is wheat or corn (to borrow your analogy), whether to include it or exclude it, etc. A passive investor don't know and don't care. Anyway, reasonable people have understood my point, so moving on.

[hillclimber]

You have a lot of opinions, I understand, many people do, that is called making active decisions based on subjective parameters. Based on evidence something that has negative impact on one's long term investing success.

How do you think MSCI and S&P came up with their market accessibility criterion?

[Elysium]

You have a lot of opinions, I understand, many people do, that is called making active decisions based on subjective parameters. Based on evidence something that has negative impact on one's long term investing success.

How do you think MSCI and S&P came up with their market accessibility criterion?

Don't know and don't have a need to know. Vanguard group and John C. Bogle figure that out; they adopted those as fine bogeys to track for millions of average investors. I was convinced they have the integrity and intellect needed to protect my interests.

[hillclimber]

You have a lot of opinions, I understand, many people do, that is called making active decisions based on subjective parameters. Based on evidence something that has negative impact on one's long term investing success.

How do you think MSCI and S&P came up with their market accessibility criterion?

Don't know and don't have a need to know. Vanguard group and John C. Bogle figure that out; they adopted those as fine bogeys to track for millions of average investors. I was convinced they have the integrity and intellect needed to protect my interests.

MSCI and S&P make "active" decisions based on subjective parameters. It's not rocket surgery.

[MotoTrojan]

Not risk-adjusted, it hasn't. The return hasn't been commensurate with the extra risk. They aren't anything special, they're just yet another category of stocks with a risk-adjusted return in the same ballpark as other categories. And they wouldn't have helped in any of the three big downturns in that time period: 2000-2003, 2008-2009, or 2020.

Holding DFA's US SCV, Dev SCV, and EM Val in 40/40/20 ratio had a higher CAGR and Sharpe than any of the 3 alone, and close to the lowest drawdown (only beat by DISVX, which was the worst overall performer).

Sure seemed to add something special to me.

https://www.portfoliovisualizer.com/bac ... tion3_1=20

[comeinvest]

Not risk-adjusted, it hasn't. The return hasn't been commensurate with the extra risk. They aren't anything special, they're just yet another category of stocks with a risk-adjusted return in the same ballpark as other categories. And they wouldn't have helped in any of the three big downturns in that time period: 2000-2003, 2008-2009, or 2020.

Holding DFA's US SCV, Dev SCV, and EM Val in 40/40/20 ratio had a higher CAGR and Sharpe than any of the 3 alone, and close to the lowest drawdown (only beat by DISVX, which was the worst overall performer).

Sure seemed to add something special to me.

https://www.portfoliovisualizer.com/bac ... tion3_1=20

What matters is total portfolio risk/return though. Not individual pieces.
So here is a better benchmark. You can see EM Value also improved portfolio's Sharpe.

Although I frequently read 2 methodologies in the comments, almost nowhere in this or other recent similar threads can I find a discussion of total world index (market cap based) vs. a fixed percentage of the various geographical regions, e.g. 50% US, 30% INTL, 20% EM (or any other fixed percentage).

Another thread that uses fixed percentages, here the small cap value tilted versions of each region, showing a great rebalancing bonus:

viewtopic.php?t=372156

I'm looking for any thoughts on the benefit of fixed percentages, to take advantage of the rebalancing bonus, similar to the rebalancing bonus that one can get from a rebalanced stocks / bonds allocation. I personally see no theoretical justification nor any practical or empirical benefit of following market cap based indexes. (One of the reasons is that it's really random anyways. Only a portion of each country's economy is traded via public securities.) But I do see the benefit of rebalancing, which is obvious in backtests. Of course, the rebalancing bonus is not guaranteed: If one country or region has higher returns forever than the rest, and that momentum never reverses, then rebalancing would result in lower final wealth than without rebalancing. But how likely is that? If one country or region were about to outperform forever, market participants would catch up to that sooner or later and bid up equities of that perceived forever outperforming country or region, and adjusted valuations would equalize the expected returns, or not?
I think the rebalancing bonus is based on the assumption that markets tend to irrationally "overshoot", based on sentiment or liquidity etc., rather than solely on fundamentals or on the prospects of the respective country or region, which results in mean-reverting behavior to some degree. If expected returns were strictly modeled by a memoryless stochastic process, I think rebalancing would be of no benefit to expected portfolio returns.
But long story short, I'm looking for papers or studies that show benefits (if any) to justify strict rebalancing between major geographical regions vs. just "letting it go" i.e. no rebalancing from an initial allocation, or vs. investing in total world.

[MotoTrojan]

Not risk-adjusted, it hasn't. The return hasn't been commensurate with the extra risk. They aren't anything special, they're just yet another category of stocks with a risk-adjusted return in the same ballpark as other categories. And they wouldn't have helped in any of the three big downturns in that time period: 2000-2003, 2008-2009, or 2020.

Holding DFA's US SCV, Dev SCV, and EM Val in 40/40/20 ratio had a higher CAGR and Sharpe than any of the 3 alone, and close to the lowest drawdown (only beat by DISVX, which was the worst overall performer).

Sure seemed to add something special to me.

https://www.portfoliovisualizer.com/bac ... tion3_1=20

What matters is total portfolio risk/return though. Not individual pieces.
So here is a better benchmark. You can see EM Value also improved portfolio's Sharpe.

Although I frequently read 2 methodologies in the comments, almost nowhere in this or other recent similar threads can I find a discussion of total world index (market cap based) vs. a fixed percentage of the various geographical regions, e.g. 50% US, 30% INTL, 20% EM (or any other fixed percentage).

Another thread that uses fixed percentages, here the small cap value tilted versions of each region, showing a great rebalancing bonus:

viewtopic.php?t=372156

I'm looking for any thoughts on the benefit of fixed percentages, to take advantage of the rebalancing bonus, similar to the rebalancing bonus that one can get from a rebalanced stocks / bonds allocation. I personally see no theoretical justification nor any practical or empirical benefit of following market cap based indexes. (One of the reasons is that it's really random anyways. Only a portion of each country's economy is traded via public securities.) But I do see the benefit of rebalancing, which is obvious in backtests. Of course, the rebalancing bonus is not guaranteed: If one country or region has higher returns forever than the rest, and that momentum never reverses, then rebalancing would result in lower final wealth than without rebalancing. But how likely is that? If one country or region were about to outperform forever, market participants would catch up to that sooner or later and bid up equities of that perceived forever outperforming country or region, and adjusted valuations would equalize the expected returns, or not?
I think the rebalancing bonus is based on the assumption that markets tend to irrationally "overshoot", based on sentiment or liquidity etc., rather than solely on fundamentals or on the prospects of the respective country or region, which results in mean-reverting behavior to some degree. If expected returns were strictly modeled by a memoryless stochastic process, I think rebalancing would be of no benefit to expected portfolio returns.
But long story short, I'm looking for papers or studies that show benefits (if any) to justify strict rebalancing between major geographical regions vs. just "letting it go" i.e. no rebalancing from an initial allocation, or vs. investing in total world.

Letting it go makes no sense to me as it is totally path dependent. If you want to have a relative momentum setup (Gary A's Dual Momentum does this between the 3 regions for example) that is one thing, but once a different region starts to outperform you should adjust to overweight it rather than just let your now outsized position in the prior winner dwindle.

I feel similarly about market-cap weighting; it doesn't isolate you from bubbles or anti-bubbles, by design you will overweight regions (or stocks...) that end up overvalued, and underweight ones that end up undervalued. That is a fact. Fixed weights eliminates this issue but you still have to have a good reason to pick the initial weighting, ideally a reason that is severed from price so it avoids that bubble linkage. RAFI fundamental weighting is one such approach you could follow and even adjust as the weights change (linked to 5 year fundamental stats, not price, so it changes slowly). https://www.rafi.com/content/dam/rafi/d ... et-usd.pdf This setup will mean you'll be counter-rebalancing, selling winners to buy losers, which fits some personalities but not others. This would be the polar opposite of the 1st suggestion to use relative momentum to overweight recent winners. Could combine the two modestly by having fixed weights (RAFI or otherwise) but having rebalance bands that aren't super tight such that recent winners have a little room to run, and then instead of rebalancing to your nominal target you simply rebalance as needed to not exceed the rebalance band. This is more or less my approach.

[comeinvest]

Not risk-adjusted, it hasn't. The return hasn't been commensurate with the extra risk. They aren't anything special, they're just yet another category of stocks with a risk-adjusted return in the same ballpark as other categories. And they wouldn't have helped in any of the three big downturns in that time period: 2000-2003, 2008-2009, or 2020.

Holding DFA's US SCV, Dev SCV, and EM Val in 40/40/20 ratio had a higher CAGR and Sharpe than any of the 3 alone, and close to the lowest drawdown (only beat by DISVX, which was the worst overall performer).

Sure seemed to add something special to me.

https://www.portfoliovisualizer.com/bac ... tion3_1=20

What matters is total portfolio risk/return though. Not individual pieces.
So here is a better benchmark. You can see EM Value also improved portfolio's Sharpe.

Although I frequently read 2 methodologies in the comments, almost nowhere in this or other recent similar threads can I find a discussion of total world index (market cap based) vs. a fixed percentage of the various geographical regions, e.g. 50% US, 30% INTL, 20% EM (or any other fixed percentage).

Another thread that uses fixed percentages, here the small cap value tilted versions of each region, showing a great rebalancing bonus:

viewtopic.php?t=372156

I'm looking for any thoughts on the benefit of fixed percentages, to take advantage of the rebalancing bonus, similar to the rebalancing bonus that one can get from a rebalanced stocks / bonds allocation. I personally see no theoretical justification nor any practical or empirical benefit of following market cap based indexes. (One of the reasons is that it's really random anyways. Only a portion of each country's economy is traded via public securities.) But I do see the benefit of rebalancing, which is obvious in backtests. Of course, the rebalancing bonus is not guaranteed: If one country or region has higher returns forever than the rest, and that momentum never reverses, then rebalancing would result in lower final wealth than without rebalancing. But how likely is that? If one country or region were about to outperform forever, market participants would catch up to that sooner or later and bid up equities of that perceived forever outperforming country or region, and adjusted valuations would equalize the expected returns, or not?
I think the rebalancing bonus is based on the assumption that markets tend to irrationally "overshoot", based on sentiment or liquidity etc., rather than solely on fundamentals or on the prospects of the respective country or region, which results in mean-reverting behavior to some degree. If expected returns were strictly modeled by a memoryless stochastic process, I think rebalancing would be of no benefit to expected portfolio returns.
But long story short, I'm looking for papers or studies that show benefits (if any) to justify strict rebalancing between major geographical regions vs. just "letting it go" i.e. no rebalancing from an initial allocation, or vs. investing in total world.

Letting it go makes no sense to me as it is totally path dependent. If you want to have a relative momentum setup (Gary A's Dual Momentum does this between the 3 regions for example) that is one thing, but once a different region starts to outperform you should adjust to overweight it rather than just let your now outsized position in the prior winner dwindle.

I feel similarly about market-cap weighting; it doesn't isolate you from bubbles or anti-bubbles, by design you will overweight regions (or stocks...) that end up overvalued, and underweight ones that end up undervalued. That is a fact. Fixed weights eliminates this issue but you still have to have a good reason to pick the initial weighting, ideally a reason that is severed from price so it avoids that bubble linkage. RAFI fundamental weighting is one such approach you could follow and even adjust as the weights change (linked to 5 year fundamental stats, not price, so it changes slowly). https://www.rafi.com/content/dam/rafi/d ... et-usd.pdf This setup will mean you'll be counter-rebalancing, selling winners to buy losers, which fits some personalities but not others. This would be the polar opposite of the 1st suggestion to use relative momentum to overweight recent winners. Could combine the two modestly by having fixed weights (RAFI or otherwise) but having rebalance bands that aren't super tight such that recent winners have a little room to run, and then instead of rebalancing to your nominal target you simply rebalance as needed to not exceed the rebalance band. This is more or less my approach.

You are alluding to factor investing approaches (momentum and/or value). I didn't even mean to go that far, which will result in a whole different discussion in and by itself. But you are right, a factor based rebalancing strategy would principally also result in rebalancing, and we would expect a rebalancing bonus in the long run due to mean reverting tendencies (I think). The difference to a factor-agnostic fixed percentage strategy would be that you would use a different model of the drivers of mean reversion.
In case of no rebalancing, the initial allocation would be selected for example by considerations of diversification of risk (e.g. I want to invest in INTL to diversify the risk of the U.S. underperforming in the future). One such approach that some people use, seems to be to invest by market capitalization. If somebody invests now in "total world" for the rest of his life, this is nothing else but "letting it go", i.e. there will never be any rebalancing between geographies or any other criteria. Yes the country percentages will change over time, but it's neither market timing, nor factor investing: The asset allocation methodology is consistent, the algo is defined ahead of time, and will require no action ever.

I think "total world" is a fair asset allocation plan, although I personally am unable to find a theoretical justification for it vs other allocations like fixed percentages. But I'm curious if there might be a systematic disadvantage or sub-optimality of this approach. It is commonly believed that a fixed percentage split with rebalancing between stocks and bonds yields risk-adjusted returns in excess of either of the two components, called "rebalancing bonus" as a nice side-effect of an asset allocation that diversifies risk between somewhat independent assets. I am trying to find a study that either suggests or refutes that there is a similar benefit of a per-country or per-region allocation with rebalancing, in comparison to "total world".

The next question of course would be how fine-grained the split should be. A similar argument could be made for a fixed asset allocation split between industry sectors within the S&P500, for example.

[squirrel1963]

I always like looking at this plot from the Credit Suisse Yearbook.
- Looks like WWII wasn't especially kind to emerging markets, unsurprisingly.
- Since WWII ended, visually, it does appear that the slope of EM has been slightly steeper than developed markets sometimes

Future unknowable, etc. etc...

Page 38, Figure 20
https://www.credit-suisse.com/media/ass ... dition.pdf

Cheers

It's so cool that the summary of Credit Suisse yearbook is available online, thanks much for the link!!!!

[JBTX]

I have had a modest overweight in EM for many years, and I am beginning to question their value do to some of the geopolitical and other intangible issues. In theory, the market should correct for those factors, but historically it doesn’t seem like they have. Nonetheless, I will stick with them because the time to buy stocks is when they are unpopular. To do the opposite seems like performance chasing.


One strategy may be to lean towards EM low volatility. You may end up getting a higher concentration of quality stocks and I’ve read you tend to have a lower concentration of government owned stocks. It does seem like they have performed modestly better.


https://www.msci.com/documents/10199/2a ... 85f129b1f5

[comeinvest]

I have had a modest overweight in EM for many years, and I am beginning to question their value do to some of the geopolitical and other intangible issues. In theory, the market should correct for those factors, but historically it doesn’t seem like they have. Nonetheless, I will stick with them because the time to buy stocks is when they are unpopular. To do the opposite seems like performance chasing.


One strategy may be to lean towards EM low volatility. You may end up getting a higher concentration of quality stocks and I’ve read you tend to have a lower concentration of government owned stocks. It does seem like they have performed modestly better.


https://www.msci.com/documents/10199/2a ... 85f129b1f5

Are there any good min vol ETFs available in the U.S.? For any market, not just EM?

[willthrill81]

Maybe a small allocation to EM is reasonable. But the key is to keep it from getting too big.

According to PV, EM had 0% real return for U.S. investors for almost a decade (1995-mid 2004) and is still 28% off its peak in 2007. That's 15 years and counting of negative real returns.

[Nathan Drake]

Maybe a small allocation to EM is reasonable. But the key is to keep it from getting too big.

According to PV, EM had 0% real return for U.S. investors for almost a decade (1995-mid 2004) and is still 28% off its peak in 2007. That's 15 years and counting of negative real returns.

EM Value from 2000 has higher overall returns than any major highly diversified asset class style

There’s no evidence we need to “keep it from being too big” (what exactly is too big)?

I think anything up to 50% or even more could be defended, given someone’s appetite and patience for risk

[JBTX]

I have had a modest overweight in EM for many years, and I am beginning to question their value do to some of the geopolitical and other intangible issues. In theory, the market should correct for those factors, but historically it doesn’t seem like they have. Nonetheless, I will stick with them because the time to buy stocks is when they are unpopular. To do the opposite seems like performance chasing.


One strategy may be to lean towards EM low volatility. You may end up getting a higher concentration of quality stocks and I’ve read you tend to have a lower concentration of government owned stocks. It does seem like they have performed modestly better.


https://www.msci.com/documents/10199/2a ... 85f129b1f5

Are there any good min vol ETFs available in the U.S.? For any market, not just EM?

Yes there are min vol ETFs for US, ExUS and emerging markets.

[Valuethinker]

I always like looking at this plot from the Credit Suisse Yearbook.
- Looks like WWII wasn't especially kind to emerging markets, unsurprisingly.
- Since WWII ended, visually, it does appear that the slope of EM has been slightly steeper than developed markets sometimes

Future unknowable, etc. etc...

Page 38, Figure 20
https://www.credit-suisse.com/media/ass ... dition.pdf

Cheers

It's so cool that the summary of Credit Suisse yearbook is available online, thanks much for the link!!!!

Since the definition of "Emerging Markets" shifts over time (Japan and South Korea in particular, also Israel) and various other issues, I have a degree of scepticism re EM indices pre early 1990s. They were really "Frontier Markets" as we know them now (places like Mexico, Brasil, Thailand etc).
And the investable market size was de minimis.

Some things have changed in a good way. Horrible macro shocks (2008-09, an existential crisis for financial markets), 2020 & the current inflation crisis have not (so far) caused "Contagion" - the dreadful experience in 1997-98 of each EM falling in succession as portfolio capital exited the next victim -- Thailand then Indonesia & South Korea then (eventually) Brasil & Russia.

Investors have become more nuanced in their understanding of markets. So the Sri Lankan collapse has not brought down India, say, or even Turkey (which is showing stress). It seems the market now accepts Balance of Payments crises may occur to some countries, but it's not a general thing. And EM policymakers have learned to reduce financial risk (eg by large Current Account Balance surpluses; large Central Bank reserves). In the case of Sri Lanka (and to some extent Turkey) the problem is that those balances have been spent defending an unsustainable currency level (presumably to hold down domestic inflation).

The shifts in composition of indices, in particular the tilt towards Chinese stocks, has made, to me, EM investing less attractive - despite the theoretical advantages. I recognise that's not an entirely rational view & suffers, perhaps, from recency effects.

[Gaston]

I would add that many countries experienced poor returns because of wars and political upheavals.

I like the above observation. And I will I admit I have baggage on this topic. I have lived and worked in a number of EM countries. They are exciting places to live but, in all too many cases, they suffer from immature and dictatorial government structures that lead to an almost continuous occurrence of Black Swan events (extreme corruption, arbitrary expropriation, currency devaluations, debt defaults, coups d’état, etc). To those who wish to invest there, I wish you luck.

[Valuethinker]

I would add that many countries experienced poor returns because of wars and political upheavals.

I like the above observation. And I will I admit I have baggage on this topic. I have lived and worked in a number of EM countries. They are exciting places to live but, in all too many cases, they suffer from immature and dictatorial government structures that lead to an almost continuous occurrence of Black Swan events (extreme corruption, arbitrary expropriation, currency devaluations, debt defaults, etc). To those who wish to invest there, I wish you luck.

The market struggles to put a PE on event risk.

So if the stock would be at PE 20x in a developed market, say 12x in an EM but 0x if bad event occurs, the market will variously, over time, value the stock at 12x, 9x, 6x, 3x and 0x if the event occurs.

Much also depends on the structure of revenues. An exporter for example may do well in a currency collapse *until* the government decides to confiscate its profits.

[willthrill81]

Maybe a small allocation to EM is reasonable. But the key is to keep it from getting too big.

According to PV, EM had 0% real return for U.S. investors for almost a decade (1995-mid 2004) and is still 28% off its peak in 2007. That's 15 years and counting of negative real returns.

EM Value from 2000 has higher overall returns than any major highly diversified asset class style

And how many investors have anything at all in EM value? It's so rarely discussed around here that it's like a unicorn.

There’s no evidence we need to “keep it from being too big” (what exactly is too big)?

Yes, there is. It's called start date sensitivity. An asset with a history of such 'spurty' performance as EM has had can be perfectly fine, but if it is a large portion of the portfolio, it's apt to result in highly erratic portfolio performance.

Using Portfolio Charts, the start date sensitivity of a 100% U.S. TSM portfolio since 1970 was 31.8%. By comparison, the start date sensitivity of a 50% EM / 50% intermediate-term Treasury portfolio was 32.6%.

It's true that if an investor has a very long investment horizon and can tolerate the volatility that such a strategy becomes more plausible, but all else being equal, investors should not prefer portfolios with very high start date sensitivity.

[Nathan Drake]

Maybe a small allocation to EM is reasonable. But the key is to keep it from getting too big.

According to PV, EM had 0% real return for U.S. investors for almost a decade (1995-mid 2004) and is still 28% off its peak in 2007. That's 15 years and counting of negative real returns.

EM Value from 2000 has higher overall returns than any major highly diversified asset class style

And how many investors have anything at all in EM value? It's so rarely discussed around here that it's like a unicorn.

There’s no evidence we need to “keep it from being too big” (what exactly is too big)?

Yes, there is. It's called start date sensitivity. An asset with a history of such 'spurty' performance as EM has had can be perfectly fine, but if it is a large portion of the portfolio, it's apt to result in highly erratic portfolio performance.

Using Portfolio Charts, the start date sensitivity of a 100% U.S. TSM portfolio since 1970 was 31.8%. By comparison, the start date sensitivity of a 50% EM / 50% intermediate-term Treasury portfolio was 32.6%.

It's true that if an investor has a very long investment horizon and can tolerate the volatility that such a strategy becomes more plausible, but all else being equal, investors should not prefer portfolios with very high start date sensitivity.

Many investors are in EM Value - Grantham, Arnott, Dalio…it may be rare on a board dominated by US TSM enthusiasts, but it’s not rare.

All equity markets tend to be “spurty”.

Many people on this board are 100% US TSM. That position is just as defensible to me as 100% EM or EM value. Similar long term returns, but returns can be very sporadic with long drawn out periods. A 50% position to EM value would be more diversified than 100% VTSAX

I wouldn’t recommend either, but there are plenty of people that put huge allocations towards certain markets

[squirrel1963]

I always like looking at this plot from the Credit Suisse Yearbook.
- Looks like WWII wasn't especially kind to emerging markets, unsurprisingly.
- Since WWII ended, visually, it does appear that the slope of EM has been slightly steeper than developed markets sometimes

Future unknowable, etc. etc...

Page 38, Figure 20
https://www.credit-suisse.com/media/ass ... dition.pdf

Cheers

It's so cool that the summary of Credit Suisse yearbook is available online, thanks much for the link!!!!

Since the definition of "Emerging Markets" shifts over time (Japan and South Korea in particular, also Israel) and various other issues, I have a degree of scepticism re EM indices pre early 1990s. They were really "Frontier Markets" as we know them now (places like Mexico, Brasil, Thailand etc).
And the investable market size was de minimis.

Some things have changed in a good way. Horrible macro shocks (2008-09, an existential crisis for financial markets), 2020 & the current inflation crisis have not (so far) caused "Contagion" - the dreadful experience in 1997-98 of each EM falling in succession as portfolio capital exited the next victim -- Thailand then Indonesia & South Korea then (eventually) Brasil & Russia.

Investors have become more nuanced in their understanding of markets. So the Sri Lankan collapse has not brought down India, say, or even Turkey (which is showing stress). It seems the market now accepts Balance of Payments crises may occur to some countries, but it's not a general thing. And EM policymakers have learned to reduce financial risk (eg by large Current Account Balance surpluses; large Central Bank reserves). In the case of Sri Lanka (and to some extent Turkey) the problem is that those balances have been spent defending an unsustainable currency level (presumably to hold down domestic inflation).

The shifts in composition of indices, in particular the tilt towards Chinese stocks, has made, to me, EM investing less attractive - despite the theoretical advantages. I recognise that's not an entirely rational view & suffers, perhaps, from recency effects.

I agree, and I don't share Credit Suisse enthusiasm for EM. The way I see it it's a lot of political risk (compared to DEV markets) that I'm not particularly willing to take given I'm retired. But I admit here that I am probably biased by my opinion of certain EM countries.

[squirrel1963]

Maybe a small allocation to EM is reasonable. But the key is to keep it from getting too big.

According to PV, EM had 0% real return for U.S. investors for almost a decade (1995-mid 2004) and is still 28% off its peak in 2007. That's 15 years and counting of negative real returns.

EM Value from 2000 has higher overall returns than any major highly diversified asset class style

And how many investors have anything at all in EM value? It's so rarely discussed around here that it's like a unicorn.

Back in 2010 or so I was a big fan of value stocks, mid cap stocks and small value, both domestic and international.
After a while I decided though that it's too much cognitive effort and I did a lot of simplification.
But I still go against BH orthodoxy and I hold some BRKB, VIG and VIGI. I know that dividends are just mental accounting, but I admit to irrationally like them and I kind of view dividend stocks as being fairly close to value stocks. Unfortunately this is not something that will probably never see a good discussion on BH. I am positively surprised that this thread has stayed classy thus far

[Northern Flicker]

That’s interesting since EM has outperformed all asset classes the past 20 years

Who controls the manufacturing btw?

I don't know where you see emerging markets beating SP500. As OP said that is not true. US controls manufacturing through its financial system and investments.

https://www.portfoliovisualizer.com/fun ... mark=VTSMX

True enough... but as soon as the start year becomes 2004, EM lags - and over the past 15 years, EM got destroyed. (Unless I'm not looking at it correctly.)

Start date sensitivity can be very similar for US TSM as well, so EM is not alone in this regard

DFEVX had the good fortune of launching at a historically great year to start a backtest with US equities. EM was coming out of devastating currency crises and US equities were at the peak of a tech bubble. And as EM countries got their finances in better order, there was a massive flow of capital from DM countries to EM countries in the period 2002-2007.

[willthrill81]

Maybe a small allocation to EM is reasonable. But the key is to keep it from getting too big.

According to PV, EM had 0% real return for U.S. investors for almost a decade (1995-mid 2004) and is still 28% off its peak in 2007. That's 15 years and counting of negative real returns.

EM Value from 2000 has higher overall returns than any major highly diversified asset class style

And how many investors have anything at all in EM value? It's so rarely discussed around here that it's like a unicorn.

There’s no evidence we need to “keep it from being too big” (what exactly is too big)?

Yes, there is. It's called start date sensitivity. An asset with a history of such 'spurty' performance as EM has had can be perfectly fine, but if it is a large portion of the portfolio, it's apt to result in highly erratic portfolio performance.

Using Portfolio Charts, the start date sensitivity of a 100% U.S. TSM portfolio since 1970 was 31.8%. By comparison, the start date sensitivity of a 50% EM / 50% intermediate-term Treasury portfolio was 32.6%.

It's true that if an investor has a very long investment horizon and can tolerate the volatility that such a strategy becomes more plausible, but all else being equal, investors should not prefer portfolios with very high start date sensitivity.

Many investors are in EM Value - Grantham, Arnott, Dalio…it may be rare on a board dominated by US TSM enthusiasts, but it’s not rare.

I said "discussed around here." And around here, it IS rarely discussed by anyone.

All equity markets tend to be “spurty”.

True, but equity slices have not all been equally 'spurty', not by a long shot. U.S. SCV has had a start date sensitivity of 19.8% since 1970 (lower than a 60% U.S. TSM / 40% ITT portfolio), whereas EM had an SDS of 54.5%, the highest by far of any equity group in Portfolio Charts.

We never know what the future holds, but it's undeniable that EM in general has been much more erratic than most other equity groups.

[willthrill81]

I don't know where you see emerging markets beating SP500. As OP said that is not true. US controls manufacturing through its financial system and investments.

https://www.portfoliovisualizer.com/fun ... mark=VTSMX

True enough... but as soon as the start year becomes 2004, EM lags - and over the past 15 years, EM got destroyed. (Unless I'm not looking at it correctly.)

Start date sensitivity can be very similar for US TSM as well, so EM is not alone in this regard

DFEVX had the good fortune of launching at a historically great year to start a backtest with US equities. EM was coming out of devastating currency crises and US equities were at the peak of a tech bubble. And as EM countries got their finances in better order, there was a massive flow of capital from DM countries to EM countries in the period 2002-2007.

And the fact that DFEVX (and EM in general) has had robustly negative real returns since late 2007 means that despite its massive runup from 2003-2007, the money-weighted returns for an accumulator could easily have been identical to those of VTSMX, and the latter had a significantly smaller maximum drawdown to boot.

This doesn't mean that EM is a 'bad' asset class at all, but I still contend that a large allocation to it doesn't seem prudent to me.

[Nathan Drake]

https://www.portfoliovisualizer.com/fun ... mark=VTSMX

True enough... but as soon as the start year becomes 2004, EM lags - and over the past 15 years, EM got destroyed. (Unless I'm not looking at it correctly.)

Start date sensitivity can be very similar for US TSM as well, so EM is not alone in this regard

DFEVX had the good fortune of launching at a historically great year to start a backtest with US equities. EM was coming out of devastating currency crises and US equities were at the peak of a tech bubble. And as EM countries got their finances in better order, there was a massive flow of capital from DM countries to EM countries in the period 2002-2007.

And the fact that DFEVX (and EM in general) has had robustly negative real returns since late 2007 means that despite its massive runup from 2003-2007, the money-weighted returns for an accumulator could easily have been identical to those of VTSMX, and the latter had a significantly smaller maximum drawdown to boot.

This doesn't mean that EM is a 'bad' asset class at all, but I still contend that a large allocation to it doesn't seem prudent to me.

This gets back to what do you consider large?

[er999]

In this podcast with Mark Mobius who was a big emerging markets guru they asked him where the emerging markets growth / profit went and he said in some cases it was captured by US companies. He gave the example of apple with their iPhones — manufactured in China and many sales in China but that growth and profit returned to apple stock and not an emerging markets fund. (https://podcasts.apple.com/us/podcast/m ... 0565996346)

[willthrill81]

True enough... but as soon as the start year becomes 2004, EM lags - and over the past 15 years, EM got destroyed. (Unless I'm not looking at it correctly.)

Start date sensitivity can be very similar for US TSM as well, so EM is not alone in this regard

DFEVX had the good fortune of launching at a historically great year to start a backtest with US equities. EM was coming out of devastating currency crises and US equities were at the peak of a tech bubble. And as EM countries got their finances in better order, there was a massive flow of capital from DM countries to EM countries in the period 2002-2007.

And the fact that DFEVX (and EM in general) has had robustly negative real returns since late 2007 means that despite its massive runup from 2003-2007, the money-weighted returns for an accumulator could easily have been identical to those of VTSMX, and the latter had a significantly smaller maximum drawdown to boot.

This doesn't mean that EM is a 'bad' asset class at all, but I still contend that a large allocation to it doesn't seem prudent to me.

This gets back to what do you consider large?

That's subjective and up to each investor to determine for themselves. There's never a clear line in the sand with such things.

Personally, I'd certainly never put more than one-third of my equities into EM of any flavor and probably more like 10-20%.

[Apathizer]

Start date sensitivity can be very similar for US TSM as well, so EM is not alone in this regard

DFEVX had the good fortune of launching at a historically great year to start a backtest with US equities. EM was coming out of devastating currency crises and US equities were at the peak of a tech bubble. And as EM countries got their finances in better order, there was a massive flow of capital from DM countries to EM countries in the period 2002-2007.

And the fact that DFEVX (and EM in general) has had robustly negative real returns since late 2007 means that despite its massive runup from 2003-2007, the money-weighted returns for an accumulator could easily have been identical to those of VTSMX, and the latter had a significantly smaller maximum drawdown to boot.

This doesn't mean that EM is a 'bad' asset class at all, but I still contend that a large allocation to it doesn't seem prudent to me.

This gets back to what do you consider large?

That's subjective and up to each investor to determine for themselves. There's never a clear line in the sand with such things.

Personally, I'd certainly never put more than one-third of my equities into EM of any flavor and probably more like 10-20%.

I agree. I posted a Felix link discussing EM in great detail. His conclusion was something like, 'I think EM has a place in a well-diversified portfolio, but would be cautious applying an aggressive over-weighting.' That's my approach. I think of EM as a beneficial diversifier since it's less correlated with US markets than developed ex-US markets. I'm cautiously optimistic it could have higher returns, but not so confident to allocate more than market-cap weight esp since it's so volatile.

[Nathan Drake]

Maybe a small allocation to EM is reasonable. But the key is to keep it from getting too big.

According to PV, EM had 0% real return for U.S. investors for almost a decade (1995-mid 2004) and is still 28% off its peak in 2007. That's 15 years and counting of negative real returns.

EM Value from 2000 has higher overall returns than any major highly diversified asset class style

And how many investors have anything at all in EM value? It's so rarely discussed around here that it's like a unicorn.

There’s no evidence we need to “keep it from being too big” (what exactly is too big)?

Yes, there is. It's called start date sensitivity. An asset with a history of such 'spurty' performance as EM has had can be perfectly fine, but if it is a large portion of the portfolio, it's apt to result in highly erratic portfolio performance.

Using Portfolio Charts, the start date sensitivity of a 100% U.S. TSM portfolio since 1970 was 31.8%. By comparison, the start date sensitivity of a 50% EM / 50% intermediate-term Treasury portfolio was 32.6%.

It's true that if an investor has a very long investment horizon and can tolerate the volatility that such a strategy becomes more plausible, but all else being equal, investors should not prefer portfolios with very high start date sensitivity.

Many investors are in EM Value - Grantham, Arnott, Dalio…it may be rare on a board dominated by US TSM enthusiasts, but it’s not rare.

I said "discussed around here." And around here, it IS rarely discussed by anyone.

All equity markets tend to be “spurty”.

True, but equity slices have not all been equally 'spurty', not by a long shot. U.S. SCV has had a start date sensitivity of 19.8% since 1970 (lower than a 60% U.S. TSM / 40% ITT portfolio), whereas EM had an SDS of 54.5%, the highest by far of any equity group in Portfolio Charts.

We never know what the future holds, but it's undeniable that EM in general has been much more erratic than most other equity groups.

https://www.portfoliovisualizer.com/bac ... tion2_3=50

Looking at this example, Emerging Markets Value outperformed MOST of the time with an initial $10k and $1k annual contributions with rebalancing and it wasn't until around 2020 where the US started to take over.

It's quite similar to the Value effect you see over TSM in general. And this was ending in a particularly terrible 15 year stretch for EM.

Though I agree that 33% is probably my max amount I'd feel comfortable with contributing. But I think having more than 10% is advantageous from a diversification standpoint.

[vineviz]

because it means instead of small amount of risky stuff (Emerging) you can achieve a better result with more amount of less risky stuff (Developed). You could simply own less bonds or lever up to have more amount of less risky stuff.

That’s not what it means.

Sharpe ratios are useless. Ignore them.

[nisiprius]

Not risk-adjusted, it hasn't. The return hasn't been commensurate with the extra risk. They aren't anything special, they're just yet another category of stocks with a risk-adjusted return in the same ballpark as other categories. And they wouldn't have helped in any of the three big downturns in that time period: 2000-2003, 2008-2009, or 2020.

Holding DFA's US SCV, Dev SCV, and EM Val in 40/40/20 ratio had a higher CAGR and Sharpe than any of the 3 alone, and close to the lowest drawdown (only beat by DISVX, which was the worst overall performer).

Sure seemed to add something special to me.

https://www.portfoliovisualizer.com/bac ... tion3_1=20

I'm not seeing it. The portfolio of three funds (blue) didn't have either the lowest standard deviation or the lowest drawdown. It had the highest Sharpe ratio (pace, Vineviz), but in a set of 0.46, 0.44, 0.41, and 0.40 I don't think that's a big standout.

What are you seeing?

[Anon9001]

One should be careful taking sharpe ratio seriously. The biggest weakness in the ratio is the numerator ie average excess return. It tends to fluctuate heavily depending on time period chosen. Rolling Sharpe Ratios is more ideal. But this is not the only problem with it. I noticed if you were to subtract RF in the numerator it would have effect on how much higher the assets sharpe ratio is % wise over the othrer assets sharpe ratio compared to not subtracting the RF in the numerator

[grabiner]

One should be careful taking sharpe ratio seriously. The biggest weakness in the ratio is the numerator ie average excess return. It tends to fluctuate heavily depending on time period chosen. Rolling Sharpe Ratios is more ideal. But this is not the only problem with it. I noticed if you were to subtract RF in the numerator it would have effect on how much higher the assets sharpe ratio is % wise over the othrer assets sharpe ratio compared to not subtracting the RF in the numerator

Sharpe ratio only makes sense for a portfolio as a whole, not for an individual asset.

For a portfolio, it does make sense; if portfolio X has higher risk and return than portfolio Y, but the same Sharpe ratio, then a portfolio combining X with risk-free assets can have the same risk and return as portfolio Y. Therefore, it is reasonable to say that X and Y are equally good.

But for individual investments, risk is relevant only in the context of your portfolio. International stock has currency risk, and thus should have a lower Sharpe ratio than US stock even if returns are equal. But since currency risk has very low correlation with market risk, adding a small amount of international stock to a US stock portfolio should decrease the portfolio risk.

[willthrill81]

One should be careful taking sharpe ratio seriously. The biggest weakness in the ratio is the numerator ie average excess return. It tends to fluctuate heavily depending on time period chosen. Rolling Sharpe Ratios is more ideal. But this is not the only problem with it. I noticed if you were to subtract RF in the numerator it would have effect on how much higher the assets sharpe ratio is % wise over the othrer assets sharpe ratio compared to not subtracting the RF in the numerator

Sharpe ratio only makes sense for a portfolio as a whole, not for an individual asset.

For a portfolio, it does make sense; if portfolio X has higher risk and return than portfolio Y, but the same Sharpe ratio, then a portfolio combining X with risk-free assets can have the same risk and return as portfolio Y. Therefore, it is reasonable to say that X and Y are equally good.

I believe that you meant 'portfolio X had higher risk and return than portfolio Y'.

Part of the trouble with using Sharpe ratios for evaluating portfolios is that the ratio isn't stable and is highly time dependent. From 1990-1999, the Sharpe ratio for a 60% TSM / 40% TBM portfolio was .93. From 2000-2009, it was .06. From 2010-2019, it was 1.18.

[vineviz]

For a portfolio, it does make sense; if portfolio X has higher risk and return than portfolio Y, but the same Sharpe ratio, then a portfolio combining X with risk-free assets can have the same risk and return as portfolio Y. Therefore, it is reasonable to say that X and Y are equally good.

Even for portfolios as a whole, the Sharpe ratio is highly problematic on both theoretical and practical grounds.

For a concise, layman's discussions, see ge.g. The Sharpe Ratio Broke Investors’ Brains:

This whole debate centers on what to use as a measure of risk, but William Sharpe never claimed it should be volatility. The Sharpe ratio was originally called “reward-to-variability” because volatility is not an identity for, nor an analogy to, risk. In 2007, volatility measures would have told you that U.S. equity funds had never been safer, on a risk-adjusted basis.

Sharpe’s famous paper addressed expected returns, but his metric’s near-universal application has been to historical returns — i.e., which manager was better over a time span. He never designed it to certify the future performance of investments. Past Sharpe ratios are not indicative of future Sharpe ratios and — given the time-varying nature of asset class and risk premia — should never be taken as a precise measure of anything.

[vineviz]

Part of the trouble with using Sharpe ratios for evaluating portfolios is that the ratio isn't stable and is highly time dependent. From 1990-1999, the Sharpe ratio for a 60% TSM / 40% TBM portfolio was .93. From 2000-2009, it was .06. From 2010-2019, it was 1.18.

IMHO one of the more direct ways to see the drawbacks to using Sharpe ratios for portfolio construction is to look at how much the allocation between assets would have varied in the past based on when the ratios were computed using historical data. This is similar to the "start date" problem.

Imagine a simple problem of constructing a portfolio to maximize overall Sharpe Ratio using the following three funds based on trailing 60 month returns.

• Vanguard 500 Index Investor (VFINX)
• Vanguard Emerging Mkts Stock Idx Inv (VEIEX)
• Vanguard Long-Term Investment-Grade Inv (VWESX)

The allocations were all over the place. Maximizing the Sharpe Ratio generated portfolios which NEVER contained all three assets, and frequently rotated from 100% of one thing to nearly 100% of another. This backward-looking approach is, essentially, a mechanized version of performance chasing: 100% US stocks at the top of the dot-com bubble, 100% bonds AFTER each most major market corrections, 100% emerging markets AT THE END of the "lost decades" for US stocks but less than 10% EM at the start of their run up.



link: https://www.portfoliovisualizer.com/rol ... bol3=VWESX

The only way to save the Sharpe Ratio would be to use expected returns instead of historical returns, but we all know how fraught with challenges that is.

[Northern Flicker]

One should be careful taking sharpe ratio seriously. The biggest weakness in the ratio is the numerator ie average excess return. It tends to fluctuate heavily depending on time period chosen. Rolling Sharpe Ratios is more ideal. But this is not the only problem with it. I noticed if you were to subtract RF in the numerator it would have effect on how much higher the assets sharpe ratio is % wise over the othrer assets sharpe ratio compared to not subtracting the RF in the numerator

Sharpe ratio only makes sense for a portfolio as a whole, not for an individual asset.

For a portfolio, it does make sense; if portfolio X has higher risk and return than portfolio Y, but the same Sharpe ratio, then a portfolio combining X with risk-free assets can have the same risk and return as portfolio Y. Therefore, it is reasonable to say that X and Y are equally good.

But for individual investments, risk is relevant only in the context of your portfolio. International stock has currency risk, and thus should have a lower Sharpe ratio than US stock even if returns are equal. But since currency risk has very low correlation with market risk, adding a small amount of international stock to a US stock portfolio should decrease the portfolio risk.

I agree, although the Sharpe ratio is an imperfect measure of risk-adjusted return. But I also would note that an international stock fund is a portfolio. Compare VEMAX an EM equity index fund with DFEMX an active EM equity fund. Both funds hold portfolios of EM stocks. We can ask the question: "was the higher risk in DFEMX rewarded?" The imperfections of the Sharpe ratio statistic to measure risk-adjusted return still apply.

But I agree that an investor primarily should be concerned with the risk and return of their overall portfolio, and not of components of it.