Compared with U.S. stock funds and broad international stock funds, funds that specialize in emerging foreign markets are a bit like Usain Bolt sprinting against mere mortals. They leave the competition far behind. But this class of investment also carries a lot of volatility.

As shown in the Lucky 13 chart below, emerging non-U.S. stocks, as measured by the MSCI EM Index, have outperformed the U.S. stocks (as measured by the S&P 500) and the stocks of developed non-U.S. markets (the MSCI EAFE Index) over the past 13 years.

From Jan. 1, 1999, to Dec. 31, 2011, the MSCI EM Index delivered a 13-year annualized return of 11.5% - obliterating the 2.3% return of the MSCI EAFE and the 2% return of the S&P 500. Based on 13-year performance, it's clear that including a diversified emerging market fund in your investment portfolio can be beneficial.

The MSCI EM Index measures equity market performance in 21 emerging nations. As of Jan. 31, 2012, there were 149 diversified emerging market equity funds in the Morningstar Principia database (counting distinct funds). Of this group, 53 had a 10-year performance history. The net assets held by all 149 funds totaled $275 billion, and as shown in The Big 25 chart, the largest 25 funds hold nearly 86% of total assets.

The two largest diversified emerging markets funds (VWO and EEM) are ETFs. Together, they possess nearly one-third of all diversified emerging markets fund assets. They both track the MSCI EM Index and have similar performance records. If cost is important, VWO is the more attractive option, with expenses of only 22 basis points.

Among the 25 largest emerging market funds, only four mimic an index (MSCI EM is the index of choice for three). That means about two-thirds of the assets are actively managed.

Does active management versus passive index tracking make a difference? Not really. As of Jan. 31, 2012, the average three-year return for the four index-based emerging markets funds was 27%, compared with 28.1% for the 21 actively managed funds. Over the past five years, the emerging markets index funds averaged a 4.2% return, compared with 4.7% for the actively managed funds.

Note that this particular group of funds is categorized as diversified, meaning they have exposure to a wide variety of emerging markets. Of course, there are non-U.S. equity categories that have a more regional focus, a different market cap target, or a value or growth tilt. The various Morningstar non-U.S. equity categories are summarized in the Where in the World? chart below and are listed by their recent three-year annualized return. The best performing category has been Latin America, followed by diversified emerging markets.



Now consider the performance of a diversified investment portfolio with and without diversified emerging stock. The diversified portfolio in this analysis consisted of equally weighted allocations in a dozen core indexes: large-cap U.S. equity, mid-cap U.S. equity, small-cap U.S. equity, developed non-U.S. equity, emerging non-U.S. equity, real estate, natural resources, commodities, U.S. bonds, TIPS, non-U.S. bonds and cash. The performance of each asset class was represented by an established index.

With diversified emerging market stock (using the performance of the MSCI EM Index) included in the multi-asset portfolio (with the 12 indexes equally weighted at 8.33% each), the 10-year annualized return as of Dec. 31, 2011, was 8.93%, with a standard deviation of 15.3%. Without diversified emerging markets included in the portfolio (the MSCI EAFE index was given a double weighting), the 10-year performance was 7.98% - a drop of nearly 100 basis points - and the standard deviation was 14.4%.

If emerging market stocks were replaced by a double dose of developed non-U.S. stocks, the standard deviation also declined. But is a 6.25% reduction in volatility, from 15.3% to 14.4%, really worth an 11.9% decline in return?

By itself, the emerging non-U.S. stock category had a 10-year annualized return of 13.9% as of Dec. 31, but it also had a standard deviation of 38% - by far the largest 10-year standard deviation among the 12 asset classes. The next closest standard deviation was natural resources at 26.9%. By comparison, the 10-year standard deviation of annual returns for the S&P 500 was 20.5% and 2.2% for U.S. aggregate bonds.

So, despite adding an ingredient with a highly volatile return pattern, the overall portfolio volatility actually increased little (from 14.4% to 15.3%). Certainly, that modest increase in the volatility of the annual returns was worth moving the 10-year return from 7.98% to 8.93%.

Put another way, compared with a 100% aggregate U.S. bond portfolio (with a 10-year standard deviation of 2.2% and 10-year annualized return of 5.78%), the jump in the multi-asset portfolio's standard deviation from 14.4% to 15.3% is insignificant. Standard deviation of both is way higher than 2.2%. In order to move the performance needle from a bond return of 5.78% to a multi-asset portfolio return of 8.93%, equity assets must be included - and doing so will increase the volatility of returns. So, the logic follows, if you're going to add equity to a portfolio, add a wide variety of asset classes - particularly classes that have significant performance potential.

Emerging market stock is like Tabasco sauce - too hot to consume by itself. But when added to a variety of other ingredients, it adds the right amount of spice. The raw heat of the Tabasco sauce is softened by many of the other ingredients without losing its impact. Emerging markets stock are clearly a great ingredient for a tangy portfolio.


Craig Israelsen, Ph.D., is an associate professor at Brigham Young University and the author of 7Twelve: A Diversified Investment Portfolio With a Plan.