An All-Encompassing Approach to Emerging Markets
The case for an active, unconstrained, multi-asset strategy
November 18, 2011
The growing strength of emerging markets has become one of the most compelling investment stories in the world today. As a group, their economies are growing rapidly, their standard of living is increasing, and their financial systems are maturing, showing remarkable resilience in recent years.
Historically, stocks provide the best way for investors to participate in long-term economic growth. Yet many investors hesitate to increase their emerging-markets stock exposure because of the volatility of returns. Despite their maturing economies, emerging-market stock volatility remains much higher than in developed markets (display).
Volatility can erode investments’ value over the long term because of “risk drag”, the corrosive effect that volatility-driven declines have on compounding.
The good news is that investors don’t have to limit themselves to stocks when seeking to profit from emerging-markets growth. There are multiple potential beneficiaries of emerging-markets growth, including bonds and currencies—and even developed-market stocks (because some developed-market companies sell into emerging markets). These asset classes benefit from emerging-markets growth in different ways and can provide investors with greater diversification potential to reduce volatility.
An investor could invest in these asset classes separately, but we believe that integrating them in one dynamically managed portfolio can generate much better risk/return potential than a stock-only strategy. An emerging-markets multi-asset strategy can provide multiple sources of return potential, and more ways to mitigate risk. Ideally, it can provide the potential for returns similar to a stock-only strategy, but with significantly less risk.
What is the best way to implement a multi-asset strategy? One could invest in separately managed stock, bond and perhaps currency funds—effectively “bolting together” the strategy. But unless the managers are coordinating their efforts, the investor may end up with a less than optimal result. For example, the funds might have similar risk control strategies, and the investor could end up with more risk control than desired in an inefficient part of the market. This points to the need for an unconstrained, holistic and integrated approach. The benefits of this approach are at least three-fold:
- First, it provides utmost flexibility to seek higher risk-adjusted returns, by broadening the opportunity set to include more and different asset classes, countries, currencies and securities than a stand-alone debt or equity portfolio could access.
- Second, it provides greater diversification potential to reduce portfolio volatility.
- Third, it opens up a wider range of hedging opportunities to reduce undesired exposures and focus on what is most essentially attractive.
Emerging market stocks are more volatile
Equity Benchmark Volatility