[This article originally appeared on our sister site, IndexUniverse.eu.]

If you ask investors why they’re putting money into emerging market equities, the answer is usually growth. Many developed markets are struggling with a huge debt burden and are set for a long period of sluggish growth. Emerging economies have much healthier balance sheets and so should outpace the developed world by a good margin over the next five years.

In that case, it makes sense to increase exposure to emerging markets (EMs). After all, EM stocks should deliver higher returns than developed ones to reflect their greater risks, while higher GDP growth should also correspond to higher returns. So there are two solid reasons to expect the EM investor to do better than one who sticks to the developed world.

At least, that’s the thinking. In practice, it isn’t so simple. To begin with, the idea that stock market returns and growth are connected is not well supported by history. In their 2002 book, “Triumph of the Optimists”, Elroy Dimson, Paul Marsh and Mike Staunton of London Business School compiled a century of stock market data for 16 developed markets, since extended to 19. They found that very long-term total equity returns and GDP growth were positively but weakly linked, with a correlation of 0.4.

The link with GDP per capita – which reflects the change in a country’s prosperity more than GDP – was weakly negative at -0.23. And in the shorter term, the connection was minimal: the relationship over 10-year periods had a correlation of just 0.12.

That’s not completely surprising, since there are many factors that can affect returns. We could consider the importance of equity markets as a source of financing, the make-up of the market versus the economy, the dependence of listed companies on their home economy and the corporate attitude to rewarding shareholders, among many others. GDP growth is clearly only one part of the equation.

Still, emerging markets differ from developed ones in many ways, so it’s not a given that the same pattern has been true there. Unfortunately, studying long-term returns in EMs isn’t easy. The same upheavals that have prevented them from developing over the last century have often wrecked stock markets or made long-term data unavailable.

Indeed, one problem with analysing long-term investment returns is survivorship bias. Many analysts generalise from the experience of the US and the handful of other markets we can easily track. This tends to ignore the markets where investors did worse. The most extreme examples are those where they were wiped out altogether, such as in Russia (the sixth biggest equity market at the start of the 1900s) and China (where stocks were said to have rallied when Mao’s communists won the civil war in 1949 in the belief that the turmoil was over).

In the latest Credit Suisse Global Investment Returns Yearbook, Dimson, Marsh and Staunton look at the history of emerging markets in more detail. Even before getting into the question of returns, one thing that stands out is the lack of advancement. Out of 38 countries that had equity markets in 1900, 17 were developed then and are developed now. Argentina and Chile went backwards from developed to emerging. Finland, Japan, Hong Kong, Portugal and Greece moved to developed, as did Singapore, where the market didn’t open until 1911.

So in 110 years, just six countries have evolved to developed status. In addition, Israel is now classed as developed by FTSE and MSCI, while South Korea was upgraded by FTSE last year. Taiwan is on watch for upgrade at some providers. So if we’re generous, we might lift that up to nine. But all told, depressingly few EMs have made the breakthrough, which is a salutary reminder that progress is not guaranteed.

By using the S&P/IFCG Emerging Index as a base, Dimson, Marsh and Staunton produced an EM index of 17 countries stretching back to 1975. Looking at this produces some interesting results. First, far from outperforming, emerging markets slightly underperformed over that period, delivering an annualised total return of 9.5% versus 10.5% for the MSCI World. Second, focusing on individual countries again suggests no link between equity returns and growth.

China’s real GDP per capita grew at an average annualised rate of 9.9% from 1985 to 2009, while its market return was just 2.6% per year. Meanwhile, India grew at 6.2% but the market returned 11.2%. Brazil rewarded investors with 11.1% from growth of just 2.9%, while Indonesia would have barely made you money (0.4%) despite decent 4.7% GDP growth.

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