Why Did Capital One Eliminate the Emerging Markets Fund?

Just a few months ago, Capital One quietly eliminated its emerging markets fund. Since that decision was announced, I’ve been trying to figure out why Capital One made this move. On the surface, it’s easy to say they eliminated it because emerging markets is volatile asset class with wild swings in both directions. I believe that’s a piece of it, but there has to be another reason why Capital One took 12% of the world’s public companies off the table for investors.

I’ve developed a theory as to what Capital One was thinking that I’d like to unpack in this article, along with an alternate route they could have gone. Before we get into that, let’s dive deeper into emerging markets. Why was it a big deal that Capital One eliminated this fund?

The Volatile History of Emerging Markets

The term “emerging markets” is used to describe countries with developing stock markets and economies, and whose regulatory systems typically aren’t as stringent as the US.

The big markets are Brazil, Russia, India, and China, and if you look closer at each of those, you can see reasons why they’re still developing. Brazil is mired in political chaos. Russia wasn’t open to American investors until after the Cold War. India has a complex economic and social system that restricts the financial opportunities of millions of its citizens. China has been getting the most attention lately, but its regulatory system is still developing, and it’s only 3% of that 12%.

Many of the emerging markets share a common theme: they rely on commodities for their wealth, which makes them less stable. If, for example, a country that depends on copper exports for its wealth sees a decline in the demand for copper, it would negatively affect that country’s stock market as all the companies tied to copper exporting took a hit.

These factors help explain the wild swings of the emerging markets asset class, illustrated below with the annual returns of the MSCI Emerging Markets Index from 2008 to 2018:

• 2008: -51.2%
• 2009: 74.3%
• 2010: 28.2%
• 2011: -14.0%
• 2012: 21.9%
• 2013: 1.3%
• 2014: 3.4%
• 2015: -11.5%
• 2016: 6.4%
• 2017: 39.5%
• 2018: -14.2%

Given those wild swings, it’s hard to know what to expect for actual wealth growth, but dollars invested since the index started in 1994 would’ve grown by 10.4% per year if left undisturbed.

By comparison, dollars invested in the S&P 500 Index would’ve grown 9.1% since 1994.

Given the up-and-down nature of emerging markets, the easy assumption is that it’s a riskier asset class. However, as these returns illustrate, that’s not the case. Emerging markets is riskier for those investors who jump in after a good year and jump out after a bad year.

This leads to my next point about Capital One’s decision.

Protecting Investors from Themselves 

The more I study the decision, the more I wonder if Capital One eliminated its emerging markets fund to save its investors from themselves. Investor fear is very real. One of the hardest parts of my job is getting clients to stick to their plan regardless of what happens in the market.

Our brains are wired to run from things that scare us. It’s a survival instinct that was essential to staying alive in the hunter-gatherer days, but it’s counterproductive to building an investment portfolio. Operating out of fear, it would’ve made sense to jump out of emerging markets after the market crashed in 2008. But look what happened in 2009: a return of 74.3%.

Conversely, our brains love the euphoria of a “win,” and we tend to want to jump into an investment when it looks like it will never stop going up, and many investors were tempted to buy into emerging markets after the recovery.

With a company as big as Capital One, helping their employees succeed is a top priority. When investors jump in and out of the emerging markets fund because of wild swings like those we saw above, their 401(k) won’t grow like it should long-term because they’re selling low and buying high. It’s a basic investing mistake, but a common one when fear calls the shots.

Capital One is likely combatting investors’ short memory spans in addition to their fear. The S&P 500 is the gold standard for investing that everyone uses as their measuring stick for other asset classes. Let’s not forget, however, the “Lost Decade” from 1999 to 2009 when the annualized total return for the S&P 500 index (with dividends reinvested back in) was -0.9%.

During that decade, emerging markets stock and developed international stocks saved the day for investors. This past decade, it’s been the reverse: the S&P 500 is holding steady, and while the annualized return from international markets isn’t negative, it hasn’t performed nearly as well as the US market. Investors asking what value there is in international markets have already forgotten about recent history.

What CapitalOne Could Have Done

So, that’s my best explanation for why Capital One made the decision it did. If what I explained above was part of the reasoning, it’s certainly understandable. Then again, I think there was a third option between “doing nothing” and “eliminating the fund” that would’ve still allowed investors access to the 12% of global economies that Capital One took off the board.

If I were in the room when Capital One executives were making this decision, I would have advocated to keep the fund and give employees some guidance on it. I’m sure Capital One advises its investors like any company does, but when you’re dealing with an asset class that triggers the fear reflex as much as emerging markets, an extra touch is needed.

To combat fear and the poor investing behaviors that result from it, advisors have to dig into risk tolerance in addition to investor goals. Are they retiring in two years or in 30 years? The more personalized the advice, the better the odds the investor will stick to the plan.

Broadly speaking, I would say that a 5% holding in a mutual fund of emerging markets is appropriate for almost any portfolio, and that investors should buy that and stick with it.

Investors should also look for an emerging market portfolio that has a low expense ratio. Some funds have very high hidden embedded costs. If you pay 2% in expenses for a particular mutual fund, that might not be worth it in the long run if there’s barely over a 1% differential between the S&P 500 and emerging markets for that time period. To keep your expense ratio low, I’d suggest a Vanguard Fund or an exchange-traded fund like iShares.