The future of emerging markets

Emerging markets have been the mainstay of the investment industry over the last few years. David Russ considers the sector's future.

Over the last decade, emerging markets have undergone an astonishing transformation that has reshaped the global investment landscape.

The decision by most emerging markets countries to pursue some form of inflation targeting following the Asian financial crisis in the late 1990s sowed the seeds of change.

Forced to tackle runaway inflation, large sovereign-debt levels relative to gross domestic product and high unemployment, developing nations implemented disciplined fiscal and debt reform.

These reforms paved the way for the accumulation of foreign reserves and the development of stronger macroeconomic fundamentals and more stable financial markets.

Key to these reforms were three fundamentals: a general switch to inflation targeting, accompanied by a greater willingness to let emerging markets currencies float; the development of domestic savings pools; and a switch from external-currency borrowing to local-currency borrowing.

The emerging markets appeal

Global investors have recognised the emerging markets evolution. Today, it is rare to find portfolios — institutional or individual — without at least some level of exposure to emerging markets.

Institutional investors have increasingly sought emerging markets exposure to diversify their portfolios and to capture global growth opportunities.

As might be expected, most initial investments have been to the broader asset classes, especially long-only equities and fixed income.

However, emerging capital markets are expanding and evolving alongside their economies. Simultaneously, alternative investments have become important facets of emerging markets.

As such, investors should consider the possible benefits — as well as the risks — of including alternatives in their emerging markets allocation and the potential impact on the efficiency of their portfolios.

Private equity in particular appears to have a favourable set of circumstances. The asset class is under-represented and could provide opportunistic investments across the capital structure.

Hedge funds are also gaining momentum as regulatory changes create a more certain investment environment.

Regulatory requirements in emerging markets have traditionally been a difficult hurdle for more complex investment areas such as alternatives.

In recent years, however, emerging capital markets activity has been enhanced by improving regulatory frameworks, encouraging foreigners to put capital to work through a variety of channels.

The case for diversification

To substantiate an argument for a diversified approach to emerging markets allocations, the following case study shows the impact of adding a comprehensive basket of emerging markets asset classes to a diversified representative portfolio.

The case study presents an example of what a diversified emerging markets ‘basket’ could look like in a representative institutional portfolio, and how that basket relates to the rest of the portfolio’s investment strategy for an optimal allocation of both assets and risk.

The basket of emerging markets asset classes is designed to have low correlations to the initial representative portfolio of existing holdings in developed equities, fixed income and alternatives.

Taking an overall allocation of 10 per cent to emerging markets in a diversified portfolio containing a mix of developed equities, developed fixed income and developed alternatives provides better returns per unit of risk and overall portfolio efficiency.

In the case study, the projected five-year performance for all asset classes is based on their respective index proxies. These indices were used to model risk/return characteristics, as well as correlations, among the asset classes.

The case study is based on a progression of three illustrative scenarios.

Firstly, a diversified representative institutional portfolio that includes exposure to developed equities, developed fixed income and developed alternative investments — but no emerging markets.

I have then taken the same portfolio and added an allocation to a traditional long-only emerging markets equities and fixed income.

In the third and final scenario, I have augmented the emerging market portion of the second portfolio by adding a well-diversified, comprehensive mix of emerging market equities, emerging market fixed income, emerging market private equity, emerging market infrastructure and emerging markets hedge funds.

The second scenario — which adds a long-only emerging markets allocation to the initial representative portfolio — has a positive impact for the investor, primarily by improving the returns per unit of risk.

But volatility is slightly higher than in the initial portfolio. This illustrates the current situation for many investors with an EM allocation.

In the third approach — which uses a more comprehensive basket, including EM private equity, EM infrastructure and EM hedge funds — the results show an improvement over the second scenario.

Returns increased further and volatility is lower, thus achieving the best return per unit of risk of the three scenarios.

This improvement was achieved by emphasising the alternative asset classes — constituting 70 per cent of the EM basket — while equities and fixed income were allocated at 20 per cent and 10 per cent, respectively.

The portfolio is most efficient with the addition of a comprehensive basket of emerging market asset classes.

The asset mix used in the third scenario was also designed to keep volatility in a lower range — similar to that of the initial portfolio.

Investors with an appetite for more risk can adjust the mix to target increased potential returns commensurate with a higher risk profile.

As performance in this case study is based on index proxies for the asset classes, additional alpha can potentially be derived via skilful manager selection and country selection.

‘Emerged’ markets are likely to offer a completely different set of opportunities (and investable instruments) than ‘frontier’ emerging nations and country-specific strategies could alter the efficient frontier.

In this light, a balanced emerging markets portfolio should seek to calibrate exposures across the risk spectrum, making use of all available instruments — including alternative investments — as well as regions, to achieve optimal potential returns that are commensurate to the amount of risk taken.

Overall, secular macroeconomic trends and capital market growth and maturation over the last decade have created a fertile ground for growth in emerging markets investments.

These include local-currency-denominated bonds, equity investments and alternatives.

In addition, private equity and hedge fund investing have become more widely available, allowing investors to diversify their portfolio allocation strategies even further.

Given historical restrictions on certain trading practices, such as shorting, some investors previously shied away from the emerging markets.

Recent changes in the regulatory environment have significantly changed the investment landscape, allowing for breadth and sophistication of capital markets.

Just as many investors have in recent years diversified their developed market investments across a wide range of assets, the same diversification approach should be considered for emerging markets investments.

David Russ is managing director and head of investment strategies and solutions at Credit Suisse Asset Management.