Emerging markets (EM) had a tough time last year, down about five percent while US markets rose by basically one-third.  Given that the losses are extending into 2014, it’s natural to wonder whether we should remain invested in EM.

The short answer is that we certainly don’t intend to withdraw or reduce our position there, and, in fact, we are actually considering increasing our allocation slightly.

Acropolis has held EM stocks since our inception more than 11 years ago and EM has been very good to us.

Over the last decade, including the declines last year and this, the MSCI EAFE EM index has gained 10.11 percent, while the S&P 500 earned 7.01 percent and the MSCI EAFE index of developed market gained 6.45 percent.

While I love those returns, what happened in the past decade doesn’t tell us too much about the next decade.  While the crystal ball is super-duper hazy, the best measure we have to gauge future performance is valuation.

Right now, valuations are attractive for EM stocks.  The price-to-book ratio for EM stocks is 3.1 according to MSCI compared to 4.6 for the S&P 500.  That’s a discount of nearly one-third.  (Developed markets stocks are even cheaper – the price-to-book ratio for the MSCI EAFE index of developed market stocks is just 2.8.)

In fact, the wild price swings are exactly what we would expect.  When we started investing in EM more than a decade ago, we knew that the volatility of EM was about three times more than the S&P 500 – which is why we have such a small weight to EM.

The last decade was an aberration in the sense that EM was only about 60 percent more volatile than the S&P 500, which is a walk in the park compared to our expectations.

In addition to the attractive valuation and ‘business as usual’ volatility, we know that including EM stocks reduces the overall portfolio risk because EM stocks aren’t perfectly correlated with domestic US stocks, our largest equity allocation.

We draw the line, however, in the bond market – we have no intention of buying EM bonds anytime soon (or anytime at all at this point).

Until last year, it was quite popular to invest in EM debt.  The idea was that EM economies were greatly improved from their serial defaulting past and their balance sheets were better than developed markets and the yields are high.

Right now, the Barclays US Dollar Emerging Markets Government bond index has a yield to maturity of 5.2 percent.  That index is hedged back to the dollar so you aren’t exposed to things like the 16 percent drop in the Argentinean peso that happened today.

If you are willing to go un-hedged, the yield jumps up to 5.6 percent, which hardly seems like enough additional yield to compensate for the risk in our opinion.

The EM bond investment was supposed to help offset losses in the US bond market, but that didn’t really happen.  Over the last 12 months, the Barclays US Aggregate did lose 1.15 percent, the hedged EM index lost 3.85 percent and the un-hedged EM index lost 6.2 percent through yesterday.

Bond investing involves risk and losses have, can and will occur, but we just aren’t interested in taking what we judge as undue risks on what is supposed to be the ‘safe side of the house.’

While the losses in EM stocks hurt (the EM bonds don’t since we don’t own them), they don’t hurt too badly.  Over the long-run, EM stocks are still likely to benefit as their economies transition and they develop their own middle class of consumers.  At today’s prices, we find them attractive and know that this price volatility is normal.

And, we’re glad that we weren’t as clever as Harvard and put one-third of our stocks into EM or, worse yet, some of our bond allocation into EM.  Egad, I would feel badly about both of those decisions!