- Emerging markets have outperformed their U.S. counterparts over the past 10 years, but with more risk.
- Diversification strategies in an emerging markets portfolio differ from those that apply in a developed portfolio.
- A multi-asset EM solution seeks to counterbalance the risks and rewards across regions and asset types.
We believe the type of comprehensive, unconstrained strategy we are able to offer is a unique approach to EM investing that can stand in investors' portfolios over time.
The underlying case for investing in emerging markets (EMs) remains compelling. With economic activity poised to account for 50% of the world's growth, strong company fundamentals and generally solid macro conditions, there's a lot to like about the developing world. But recent performance might make it easy to overlook these facts. The downside in EM investing is real and it's unsettling, but the upside cannot be ignored. Here, Jeff Shen and Rodolfo Martell discuss the opportunities and challenges, and introduce a multi-asset strategy that seeks to manage volatility and balance the risks and rewards inherent in EM investing.
- Higher growth, higher volatility. EM stocks and bonds have more than doubled the returns of their U.S. counterparts over the past 10 years, but with considerably more risk. (See charts below.) This has caused some investors to steer clear—or worse, to try to time the markets, usually with detrimental results.
- EM diversification is complicated. Traditional ideas around diversification may not apply in emerging markets because EM equity and EM debt are highly correlated. Investors need to rethink their approach to balancing risk and return, recognizing that what works in developed markets may not necessarily work in emerging markets.
- A multi-asset solution can address both of the above. A professionally managed portfolio constructed so that EM equity, debt and alternatives complement one another can adapt to changing market dynamics and offer a long-term EM solution.
Why should investors have EM exposure in their portfolios?
For investors seeking a source of growth for their portfolios, the developing world is an unmatched source of potential. Emerging markets are the new drivers of the global economy. Company growth is strong and credit conditions are solid. EM populations are generally young and seeing rising incomes, wealth and, in turn, spending and investment. This stands in stark contrast to much of the developed world, where economies are mature, populations are aging, and gross domestic product (GDP) will be muted as post-financial-crisis austerity measures dampen growth. Just consider the disproportion between EMs' share of world GDP (51%) and population (84%) versus their share of stock market capitalization (12%). (See bar chart EM Market Cap Has Room to Grow.) Clearly, there is significant room for growth in EM assets. But while showing great promise, EMs are volatile and increasingly complex.
What makes EM investing more volatile and complex today?
We would cite two key factors. The first is something that is very real to investors in the current moment, and that is the potential for significant drawdowns. International investing, especially in EMs, is subject to heightened risk, including the risk of increased volatility due to adverse political, economic and other developments. So while EMs have offered returns that far outpace their U.S. counterparts over the long term, true to form, they also have been subject to significant volatility along the way. (See charts below.) Investors are not built to stomach 25% volatility, and that is leading to poor investor behavior, including buying high and selling low and a general under-investment in high-potential EMs.
Second, correlations between developed and emerging markets are not what they used to be. In the past, investors enjoyed the benefits of an asset class with very low correlations to developed markets. Tighter correlations today (which are understandable given the integration of emerging countries into the global economy) dilute that diversification benefit.
In addition, EM equity and debt themselves are highly correlated, so combining the two doesn't give you the type of risk/reward offset that you might expect when you build a seemingly diversified portfolio of stocks and bonds. U.S. stocks and high yield bonds offer a familiar comparison. While different asset classes, the two have responded to economic and credit conditions in the same way and, therefore, they are very highly correlated. When U.S. stocks decline, high yield bonds (unlike traditional bonds, such as Treasuries) generally will decline, and vice versa. The same has been observed with EM stocks and EM debt. EM debt does not diversify an equity portfolio like traditional U.S. bonds, but acts more like U.S. high yield (see table below). Because EM debt is highly exposed to credit and foreign exchange (FX) risk, is has a very high correlation to EM equities.
So, the bottom line is that the natural instinct to combine EM debt and EM equity may not achieve the type of diversification benefit you might expect. It's more akin to diversifying U.S. stocks with U.S. high yield.
So what is the "right" way to invest in emerging markets today?
We have identified what we believe to be a better way to capture the full potential of emerging markets with less volatility. It is a multi-asset approach that considers the complete opportunity set in EMs. The strategy invests across equity, debt and alternatives in a manner that very purposefully seeks to exploit opportunities for growth, aiming to earn returns similar to EM equities while mitigating volatility.
If you think about it, this type of single-vehicle, multi-asset strategy has been successfully offered in developed market portfolios for some time, but is still a new concept in EM investing. Diversification, whether in a developed market portfolio or an EM vehicle, does not ensure profits or prevent loss. But we find this type of well-balanced approach has the potential to reduce the impact of shocks from any one source and provide for a more consistent experience over time. We believe it is far superior to the traditional piecemeal approach to EM exposure that often has led to that poor investor behavior we mentioned earlier and, ultimately, to suboptimal results.
Even if you're investing in the best EM equity fund out there, or the best EM debt product, you're missing out on the full scope of the opportunity. You're also subjecting yourself to those substantial drawdowns that can plague either asset class when there are no offsetting mechanisms in place. Our strategy, we believe, is greater than the sum of its parts—and this is a critical distinction.
Within that construct, what is your approach to EM equity?
We believe investors need to fundamentally rethink what it means to be an investor in EM equities. The same methodologies that served them well since MSCI launched the first comprehensive EM index 25 years ago may not provide adequate risk-adjusted returns over the next 25. In fact, the MSCI EM Index represents only 4% of the stocks listed in the emerging world. The MSCI EM Small Cap Index covers an additional 9%. We're not suggesting it would be possible, or even desirable, to track all 18,000 listed EM stocks. But we strongly believe there is great opportunity to add value by providing equity exposure designed to better capture the true drivers of growth in EM economies.
To that end, we take a bottom-up, security-by-security approach that is unconstrained to an EM benchmark. Our goal is to identify stocks with exposure to the vast growth indicative of the EM landscape. Our universe consists of those 21 countries that carry the EM moniker, giving us direct exposure to EM growth; 25 frontier markets for potentially high growth with lower correlation to EMs; and 24 developed markets that are home to global companies with high exposure to EM growth. This, we believe, enhances the diversification of our equity portfolio while lowering volatility.
How do you approach EM debt?
As we mentioned before, EM debt is highly correlated to EM equity. For that reason, we want to build an EM debt portfolio singularly focused on reduced correlation to EM equity. We also want to achieve a better balance between interest rate and credit risk, with higher growth and income expectations than developed market fixed income.
Overall, we like what we're seeing in EM debt, and the opportunity is only growing. (See bar chart above.) Growth in EM economics is greater than in developed markets, making for higher yields. That alone is incentive. But if we examine debt levels and fiscal balances throughout the world, we find that EMs look healthier than developed markets on both counts, and that emerging countries are now net creditors to the developed world. While debt-to-GDP ratios have increased dramatically in the developed world since 2000, they have declined in emerging countries.
So it's easy to understand why EM debt, often considered a high-risk, niche asset class, should be considered a prime candidate for inclusion in a diversified portfolio.
How specifically do you manage EM debt to mute that correlation with EM equity?
It starts with the realization that risk in EM debt is disproportionately driven by credit and foreign exchange risk (at roughly 70%) versus interest rate risk (at roughly 30%). As we noted before, this is precisely what you would expect to see of U.S. high yield and is very different from U.S. Treasuries, which are concentrated in interest rate risk. Our goal is to invest in EM debt in such a way that we are flipping that equation so that our portfolio's bond risk is 30% credit and FX risk and 70% interest rate risk. To do that, we focus primarily on U.S.-dollar-denominated debt with longer maturities and higher quality. We've found this allows us to build an EM debt portfolio with a negative correlation to EM equity (-0.20)—far different from what you would typically expect of the EM equity/EM debt relationship (+0.75). Not only are we removing the correlation with EM equity, but we're also achieving higher expected growth potential than could be realized in developed market fixed income today.
But the EM indexes certainly have been challenged of late. Why would I invest now?
If you're applying the wisdom "buy low, sell high," then now is an opportunistic time to enter EMs. But, as we've said, it's difficult to do well on your own, and that's precisely why we believe this sort of vehicle may be ideal for those who want to dip their toe into emerging markets investing. It's comprehensive, unconstrained and very specifically managed to counterbalance the risks and rewards across regions and asset types. In addition to EM equity and debt, it incorporates exposure to EM alternatives, which have the potential to deliver an uncorrelated pattern and source of returns while further enhancing diversification. The goal of this approach is not to hit a homerun in EMs every single time. It might trail straight EM equities in short-term booms, but we believe it will provide a higher return/lower volatility experience over full market cycles while diversifying a primarily domestic portfolio. It precisely addresses the issues that we identified at the start—it seeks to manage out the intense volatility inherent in EMs, it aims to lower correlations in an effort to enhance diversification and it relieves investors of having to navigate these complex markets and choose on their own. Unlike other EM offerings, we believe it can stand as a core holding in most investor portfolios.
How much EM exposure is appropriate for the average investor today?
This is largely specific to an individual's time horizon and risk tolerance. However, the data shows that the average U.S. investor is underweight EMs, with an allocation of only 5% versus EM's 12% share of global market cap. This tells us that most people should consider increasing their exposure.In most cases, we believe an allocation closer to 18% may be appropriate. We base this on our analysis of EMs' current representation in world markets and the prevailing opportunity set. U.S. investors today face longer retirements than any generation before, and they need growth to fund it. We think EM investments should be part of that growth plan. And we believe the type of comprehensive, unconstrained strategy we are able to offer is a unique approach to EM investing that can stand in investors' portfolios over time. It is designed to be an investment, not a trade.
Ultimately, we believe the majority of investors could benefit from some exposure to EMs. And given the complexities, we think it makes sense to gain that exposure through a professionally managed and diversified portfolio. As the largest manager of EM assets, BlackRock has more than 100 professionals on the ground combing for opportunities around the globe. It's a rare viewpoint that we are excited to express and share with our clients via our investment portfolios, and we're pleased to bring all of this to bear in a unique multi-asset EM vehicle.