Just a few years ago, the so-called BRIC countries (Brazil, Russia, India, China) were riding high. Many analysts saw them as “the future” in an energy scarce world with the USA in decline. So for a while there, the BRICs play attracted huge investment inflows. But in 2014, the BRICs experienced a tumultuous year that caused many investors to lose confidence in their capital markets.
Brazil went through a drought and the surprise re-election of its leftist president. Russia suffered U.S. sanctions on its economy and saw its currency plummet in value. The resource-dependent economies of both Russia and Brazil also got hurt by falling commodity prices.
India and China fared relatively better. Yet their respective stock markets still underperformed the U.S. The BRICs, and emerging markets in general, have severely underperformed for an extended period.
Weakness in Foreign Currencies
Weighs on Foreign Stocks
A major culprit is the surprising strength in the U.S. dollar in the second half of 2014. The U.S. Dollar Index rose to multi-year highs against a basket of foreign currencies. A rising dollar versus other currencies forces the repatriation of capital and debt back into dollars, which in turn drives more dollar strength and puts pressure on foreign markets.
When you invest in foreign stocks as a U.S. investor, your returns will be affected by currency translation. For example, if a foreign market falls 10% in terms of its own currency, and you own an exchange-traded fund that tracks that market, your loss in dollar terms may be larger or smaller than 10% depending on how that country’s currency moves versus the dollar.
Some ETFs and mutual funds that hold international equities engage in currency hedging. The aim is to try to capture gains in foreign markets before adjusting for currency appreciation/depreciation. But since most investors already have the vast majority of their liquid net worth in dollar- denominated assets, currency hedging defeats the purpose of international diversification. From a strategic standpoint, it makes a lot less sense to hedge now than it did a year ago, before most foreign currencies proceeded to fall sharply.
The Countries Likeliest to
Deliver Outsized Gains
Today, many foreign currencies are undervalued relative to the dollar. Most foreign stock markets are undervalued relative to the U.S., and the biggest undervaluations are in emerging markets. The weakness in emerging market stocks has certainly been frustrating for holders of such investments. But it’s underperformance that creates the exceptional values and favorable buying opportunities that may now be at hand.
Researchers at GuruFocus have calculated implied future returns over an 8-year period for various markets around the world based on current valuations. The deeper the valuation discount relative to expected earnings growth, the bigger the projected returns.
Of course, there are a lot of embedded assumptions in these projections. The only thing that is certain about forward-looking assumptions is that not all of them will prove out. Nevertheless, we can reasonably expect to be rewarded more over the long-term by buying what’s relatively cheap today.
Constructing a Foreign Stock
Portfolio BRIC by BRIC
If the aforementioned analysis holds merit, then investors who seek above-average returns in the coming years, should avoid the S&P 500 and most European markets. The Asia region (excluding Japan) offers a better risk/reward profile at this juncture.
Focusing on the BRIC countries in particular may offer investors the best risk/reward characteristics. And yes, there are ETFs for that! Consider the Guggenheim BRIC ETF (EEB), which holds dozens of the largest stocks from Brazil, Russia, India, and China.
If oil rebounds (and it will eventually, if not this year), then resource-rich Brazil and major oil exporter Russia stand to lead the BRICs into a recovery. If oil prices stay low, then the recovery may be delayed or muted unless the China and India components of the portfolio significantly outperform.
Investors who seek broader exposure to more markets that may be ripe for the picking in 2015 may prefer to own Vanguard FTSE Emerging Markets ETF (VWO). Its country allocation breaks down as follows:
- China 21.5%
- Taiwan 13.7%
- Brazil 12.5%
- India 11.1%
- South Africa 9.0%
- Mexico 6.1%
- Russia 5.2%
- Malaysia 5.0%
- Thailand 3.1%
- Indonesia 2.9%
I don’t have any prediction on whether VWO will outpace EEB’s BRICs-only portfolio in 2015. But I suspect that over the long-term Vanguard Emerging Markets will deliver better after-expense returns. That’s because VWO’s expenses come to just 0.15% annually – 49 basis points lower than EEB’s. Over time, those savings add up!