The long-term case for investing in emerging markets is well established and there are still opportunities for capturing attractive returns. However, investing in this part of the world can be a volatile experience. Emerging market equities have climbed in the last two decades, but not without going through periods of sharp decline.
Since we started managing the world’s first emerging market equity fund in 1986, new ways to invest for a smoother pattern of returns have emerged. Emerging market multi-asset (EMMA) strategies are one of the options for investors seeking a better balance between risk and return.
EMMA strategies invest across the entire spectrum of emerging market securities to access a wide range of opportunities. The investible universe comprises securities from more than 60 countries, including large-cap equities and inflation-linked bonds (Figure 1). Broadening a portfolio to include bonds and currencies can create meaningful diversification and help dampen volatility from equities without overly sacrificing returns. Designed well, an EMMA strategy potentially delivers emerging market equity-like returns with lower volatility.
Figure 1: Gain exposure to diverse markets through an EMMA strategy
Segment sizes are for illustrative purposes only and are not representative of actual portfolio holdings.
An EMMA strategy can prove effective at preserving value in difficult market conditions. This is a crucial feature because large declines can destroy long-term investment results, as two major sell-offs in emerging market equities between 1994 and 2004 show (Figure 2).
We demonstrate the downside protection that an EMMA strategy can provide. During the market downturn in 2008, emerging market equities declined by more than 50% but an EMMA approach would have fallen by less than half that amount. In 2009, emerging market equities rebounded strongly. But over that two-year cycle, the EMMA strategy would still have come out ahead with positive returns.
Figure 2: Large market declines can hurt long-term returns
Taking a bottom-up and flexible approach
There are different ways of putting together an EMMA strategy, but we believe that it is particularly effective when it is built from the bottom up, based on each security’s risk-return profile. Such a strategy would compare different securities, say a stock with a bond, and pick the most attractive to invest in.
That assessment of relative opportunities is much weaker with a top-down approach that simply bolts together separate emerging market equity and debt indices. In fact, such a top-down approach can result in overexposure to certain countries or sectors that dominate the equity and debt indices.
We also believe that an EMMA strategy goes beyond companies based in emerging markets – it should have the flexibility to invest in companies with significant emerging market exposure, no matter where they are based. In the developing world, emerging market companies tend to have a large presence in certain sectors such as financials and energy. However, in areas like healthcare and branded consumer goods, developed market companies often capture a large part of demand growth. An EMMA strategy that looks beyond geographies to invest in companies with the most attractive emerging market exposures provides investors with many more opportunities.
Pulling the equity and bond levers
A nimble and bottom-up EMMA strategy is able to make deliberate risk-return trade-offs to pursue returns with lower volatility. For example, it can choose between holding shares and bonds in a certain company, depending on the market environment. The shares may offer good potential for capital appreciation but display considerable volatility; the bonds may offer a modest but stable yield.
There is also the flexibility to choose between equity and debt at the country level. In particular, the sovereign debt universe has developed swiftly: investment grade bonds from some countries can help reduce portfolio volatility, while bonds from other countries can offer opportunities for meaningful returns. Taking Brazil as an example, its bonds offer attractive yields, and stocks in the country may not generate comparable returns despite carrying similar levels of sovereign and currency risks.
Ultimately, investors who view emerging markets holistically can gain broader exposure to the markets’ dynamism and also more options for managing risk. A well-designed EMMA strategy that invests across equities, bonds and other assets paves the way for investors to seek equity-like returns with lower volatility.
