Emerging equities: how to get away from the index?

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The attributes of emerging markets have long been recognised in the form of  abundant economic literature on the subject. Economic, financial, political and geostrategic arguments have all pointed to outperformance of emerging market equities relative to developed markets. This is borne out by the MSCI Emerging Markets index’s +14.5% average annual return since 2002. And yet, this index still accounts for just 15% of the total market cap of the MSCI All Countries index, which includes both emerging and developed economies. So there is an appreciable future margin for manoeuvring allocations higher. During the current phase of uncertainty about the prospects for major developed economies and a continuation of the low interest rate regime, it is hard to resist such a temptation.

On the other hand, emerging markets are risky. A year like 2008 proved to us that they can lose more than half their value in one year (-53% in 2008) and then gain 79% the following year. (It is worth keeping in mind that -53% + 79% is still negative due to the compounding effect). Moreover, emerging markets are both heterogeneous and dispersed. The MSCI Emerging Markets index accounts for just 15% of total market cap, but with 700 stocks in 21 countries. It is almost impossible to group this universe together. Just imagine a discussion between a Russia analyst specialising in oil stocks, and a South America or Asia ex-Japan analyst, probably affected with his own set of  biases.

In addressing this dilemma, the conventional trade-off is to impose a double constraint, i.e., to limit one’s index investments to major indices that are weighted by market cap and to consign emerging equities to the ‘alternative’ allocation, with the other portfolio base asset classes. This explains why indexed vehicles, ETFs in particular, have expanded so much in these areas. Surprisingly, indexed management is ultimately more common in markets that would appear to be subject to less arbitrage and where, in theory, there should be greater opportunities for active management.

And yet, there exist active investment methods that make sense for dealing with large investment universes. These are systematic (or algorithmic) management strategies that do not involve human intervention in selecting and weighting stocks, thus making them insensitive to the size and diversity of the universe. However, this doesn’t make them index strategies, as they can make large bets compared to conventional indices. Within this large systematic management family, there is a sub-group that is quite well suited to emerging equity problems – low-volatility strategies.

These strategies were originally identified for application in developed markets to tap into the anomaly of low volatility discovered by Professor. Robert Haugen in the 1970s. They pick stocks, thus tapping into diversity, but without using complicated models. They can therefore be applied to emerging markets, with the collateral effect of reducing absolute investment risk. These characteristics are particularly effective in emerging markets.

Strangely enough, these strategies are also ‘surprisingly human’, as they identify risk phenomena that humans are only now beginning to sense. For example, the fact that the main emerging markets (the BRICs) have become so speculative that it’s now better to opt for their close cousins (e.g., Indonesia rather than India, and Chile rather than Brazil, etc.) is an obvious conclusion for an algorithm that takes risks into account, but not for a human, especially a benchmarked one. In terms of sector breakdown as well, this type of algorithm can teach us a lot about how humans can be taken in by fads.

Since Kasparov lost to Deep Blue in 1997, computers have generally been considered to be better than humans at chess. Human players are still better at strategy but can no longer cope with the sheer volume  of data. When will there be greater awareness of the great chess match of investing in emerging markets?

Emerging markets is one of the nine themes which we think reflect investors’ key priorities this year. Linked to those themes we have chosen funds which we believe represent the most relevant solutions to the challenges of the current market environment as well as the evolving needs of our clients.

Emerging markets: trust our experts in the field

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, portfolio transaction, liquidation and custody services for funds invested in emerging markets may carry greater risk.

Etienne Vincent

Global Head of Quantitative Management

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