Investing in emerging markets...

The slower economic growth prospects for both the U.S. and Europe have been prompting a growing number of investors to focus a larger share of the investment allocations to emerging markets where a healthier economic environment and sounder policies ensure that growth rates will remain above average for some time to come.

Whilst there is no denying the relative attractiveness of emerging markets at this particular point in time, there is the traditional tradeoff of greater volatility or risk in return for the expectations of higher returns.

There is, however, an additional risk factor that should not be overlooked. The price / earnings ratio (P/E) of developing markets tend to be higher than those of developed markets and right now the difference is rather important given the growing enthusiasm for emerging market investing. The graph above shows the difference in P/E ratios between the U.S. and China. Trouble with high and expanding P/E ratios is that it may be signaling bubble territory which means that there may be a real risk of a sharp correction sometime down the road.

Considering the degree of globalization and integration of economic markets across the globe, a more effective and less volatile way of investing into emerging markets may be through developed market stocks. Given their lower relative P/E ratios, longer history, corporate culture and growing exposure to emerging markets, a number of developed market firms may in fact provide a more effective manner of gaining exposure to emerging markets at a lower volatility to comparable firms in the region. Food for thought.

Rebalancing relative to market values...

Rebalancing a portfolio can be perceived as a contrarian approach to investing and rightly so because what you are effectively doing is selling the asset that is performing well and buying the one that is not. This strategy can be highly effective in a directionless market and much less so if markets are heading in one direction all the time (as they did between 2003 and 2007).
How less effective it is also depends on a number of factors, one of which is the width of the rebalancing bands that the portfolio manager has defined. If they are too narrow and therefore trigger frequent rebalancing in a directional market environment, the portfolio will be less effective in capturing positive returns than say a portfolio with more generous bands or a buy and hold strategy.
On the other hand, if the markets are directionless (i.e. trendless), a rebalancing strategy is bound to be substantially more effective than a buy and hold strategy.
When constructing a portfolio, one of the main tasks is to define the asset allocation for the various asset classes. The main building blocks of an optimal asset allocation portfolio include historical data for the asset classes, the objectives and constraints of the investor, the impact of economic policy and current market values of assets. Among these variables, only one happens to be backward looking (historical data).
Most of these variables can be plugged into an optimizer to generate an efficient frontier on which an optimal portfolio can be devised as a function of the risk/reward appetite of the investor.
Once the portfolio is fully invested, in order to preserve its "optimal" risk profile, it needs to occasionally be rebalanced . A major drawback with this traditional approach to portfolio construction is that it totally fails to take into account the collective market perception of risk. The market values of the various assets in effect reflect the collective market perception as to the riskiness of those assets. By not taking this into consideration, the portfolio manager may in effect be taking greater or less risk than what was originally planned.
As an example, following the severe stock market correction of 2008, managers that followed a stict rebalancing regimen may have inadvertently increased the risk profile of their portfolios. In other words the portfolio may be overweight stocks relative to the markets.
So what are the lessons to be drawn from all this? If we want to ensure that risk profiles are preserved more effectively, we need to somehow find ways to reflect market values in the portfolio. At a strict minimum one should keep track of the market values of the various asset classes and compare their change through time to the same asset classes in the portfolios.