The benefits of a multi-strategy approach to emerging markets

Jai Jacob explains the approach pension funds should take when investing in emerging markets

Most investors agree that emerging market economies are currently better placed than their developed peers at the current point in the economic cycle. Emerging markets countries have better growth prospects, lower debt levels and a healthier fiscal situation than the developed world. Yet when we ask what their allocation to emerging markets is, we discover that most only invest between three to five per cent. It seems logical that investors need to raise this allocation in the medium to long term, though there remains some hesitancy in the market when it comes to taking the plunge. We believe such hesitancy comes from two perfectly rational concerns; the volatility in the asset class and the point of entry risk or timing the market. We believe using an emerging markets multi-strategy approach addresses both of these concerns and encourages investors to reconsider their underweight to the emerging markets.

1: Volatility
For those investors looking to align a portfolio with the emerging market growth story the options are numerous, yet few alone will provide a relatively smooth pattern of returns should volatility spike more regularly.

The case for emerging markets has been made again and again, but this does not stop many investors fleeing the asset class at the first sign of market volatility. This of course includes the current wave of volatility, which has not actually emanated from the emerging markets. On these occasions, though fundamentals may be strong, outside factors can come into play. At present, the eurozone crisis has continued to put pressure on emerging markets equities. With the exception of Eastern Europe, indebtedness is not an issue for the larger emerging markets; the region is the victim of a flight to safety.

A multi-strategy approach can be a way of participating in the market’s upside, while minimising losses in times of heightened volatility. Different market conditions call for different portfolio configurations. This is especially true in today’s marketplace where sentiment can change so rapidly. We believe investors can potentially achieve more meaningful diversification when different approaches and different asset classes are blended together. The result is a diversified portfolio of equity, currency and fixed income securities, which should provide an opportunity to improve the risk/return profile for investors. When investors are able to manoeuvre, not just between equity and debt, but within those asset classes, they can truly unlock hidden value in emerging markets. For example, employing an equity value style in times of uncertainty when markets are flat or falling, and employing an equity growth style when markets are in an expansionary phase can help improve long-term performance in emerging markets.

Below are examples of the methods, within fixed income and equities, which can be accessed to reduce volatility in a multi-strategy approach:

Equity value
An equity relative value approach can be used to smooth volatility when markets are flat or falling. This equity style is important to turn to when uncertainty or potential crisis looms in the emerging markets marketplace. Our equity relative value approach focuses on sustainable profitability, free cash flow and attractive valuations, and defines value based upon return on equity, valuing dividends and share buybacks.

Equity growth
When companies in emerging markets are expanding capacity either domestically or internationally equity relative growth is likely to be the most appropriate style. With a focus on capital expenditure, our approach can potentially catch a significant portion of the upside in a rising market. Shares of relative growth companies have a greater chance of outperforming when volatility levels drop below their long-term average; however, they tend to be more expensive, in general, as they often require debt to fund their growth, and may find their ability to grow hindered in a volatile market. As such, our relative growth approach is based on a trade-off between growth forecasts and valuations.

Income
Our income component looks to monetise shifts in government policy and changes in currency regimes across emerging markets.

Debt
As a way of protecting capital, emerging markets debt is a growing area with local currency, hard currency, inflation-linked securities, derivatives, securitised debt and cash. This also provides a wide range of tools to generate alpha and reduce a portfolio’s correlation with the wider market and dampen volatility.

2: Point of entry risk
With relatively regular drawdowns and rallies, it can be difficult to pick a suitable entry point in emerging markets if one only considers one style or asset class. A balanced approach should create a more stable, less volatile pattern of returns, reducing market timing risk when entering the market. Drawdowns are shallower and shorter, and recoveries faster, when mixing debt and equity. Also, not only is volatility reduced, but returns are enhanced by blending styles. This smoothing effect can be further enhanced by combining both value and growth equity styles and hard and local debt.

Emerging markets drawdowns can be sharp and recoveries long and painful. This is why many equity investors will move what little they have invested out of the asset class and back into developed markets that are, at present, hardly offering steady returns. By introducing the debt component to a hypothetical portfolio based on indices, volatility was historically reduced by one-third and long-term returns enhanced. Therefore, point of entry risk is reduced as drawdowns will be more forgiving and recoveries less drawn out.
Investors can maintain their exposure to emerging markets, capturing the long-term growth potential of the asset class.

Conclusion
A multi-strategy approach to investing in emerging markets can be valuable when the macro environment shifts as violently as it has done over the past year. At present, equity valuations are at attractive levels and within fixed income, fundamentals in many emerging markets countries remain solid. Overall we believe the global outlook is positive for the emerging markets and an emerging market multi-strategy approach is an attractive way to access the asset class.


Written by Jai Jacob, portfolio manager/analyst at Lazard

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