Emerging markets stocks have been the premier asset class over the past five years, producing an
annualized return of 33.8%, as measured by the MSCI EM index. This equates to a 330% cumulative
return, versus a 66% total return for the S&P 500 and a 138% total return for foreign developed markets
stocks, as measured by the MSCI EAFE index (see Exhibit 1).



Emerging markets stocks have demonstrated their diversification benefits as well. In the past year, as the
U.S. economy has fallen into recession due to the credit and real estate busts and oil price shock, emerging
economies and stock markets have powered ahead. In the past 12 months, the emerging markets index has
delivered a total return of 21.9%, while developed markets indexes have produced losses, and the EM index
has had a relatively low 0.65 correlation with the S&P 500.

Given the spectacular returns that emerging markets stocks have generated over the past five years, and the
heightened risks confronting global financial markets, investors have a number of questions to contemplate:
1. Have emerging markets stocks become an overvalued asset class?
2. What are the return prospects for emerging markets stocks over the next five years?
3. What is the right allocation to emerging markets stocks in a global equity portfolio?
4. How can an investor manage risk in this volatile equity asset class?
5. What are the most attractive ETFs on the market today for investing in emerging markets stocks?

Have Emerging Markets Stocks become an Overvalued Asset Class?

The valuation of emerging markets stocks has definitely increased over the past five years, but not to the
degree that one might expect given the huge appreciation in stock prices (see Exhibit 2). The increase in
valuations has been held in check by the rapid earnings growth for emerging markets stocks, which has
exceeded 20% per annum.



Prior to the bull run of the past five years, the price-to-earnings (P/E) multiple of emerging markets stocks
historically averaged approximately 75% of the P/E multiple of developed markets stocks (including the
U.S.), and the price-to-book multiple averaged 67% that of developed markets. Over this period (1985-
2002), whenever emerging markets valuations moved to parity or to a premium to developed markets
valuations, it was a signal to reduce exposure or avoid the asset class. The traditional attitude towards
emerging markets stocks was that they warranted a discounted valuation because of their greater risk
characteristics, their dependence on export activity rather than domestic demand, and their propensity to
suffer political and economic crises.

Today, emerging markets stocks are valued at a significant premium to foreign developed markets stocks
and a modest discount to U.S. stocks (see Exhibit 2). The current 20x P/E multiple of the S&P 500 is
somewhat misleading because of the heavy write downs that U.S. financial firms have taken in recent
quarters. On the basis of calendar 2008 estimated earnings, the P/E multiples of the S&P 500 and the
emerging markets index are much closer, at 15.7x, and 13.9x, respectively.

In light of the richer valuations now placed on emerging markets stocks, should investors be reducing their
allocations to the asset class or perhaps concentrate their international stock exposure in foreign developed
markets stocks where valuations seem relatively cheap?

Several factors seem to argue in favor of maintaining commitments to emerging markets and perhaps
looking instead to enlarge exposure to the asset class when opportunities present themselves. As a result of
(1) globalization; (2) the spread of prosperity on an unprecedented scale within developing economies; and
(3) the transition from a long-term bear market to a long-term bull market in natural resources, emerging
markets have undergone such a dramatic transformation this decade that they bear little resemblance to
their condition in the 1980s and 1990s. Financially, emerging economies have become creditors in the
global economy, collectively amassing huge annual current account surpluses and controlling threequarters
of the world’s foreign exchange reserves. The currency devaluations and debt defaults that plagued
emerging economies in the 1990s seem like a very distant memory.