Emerging Markets / Multi-Asset

Emerging Market Investors Don't Have to Take Volatility Lying Down

By Sharon Fay, Morgan Harting August 06, 2012

We believe that emerging markets often offer better growth prospects than most developed markets. But, as my colleague Morgan Harting argues, many investors are not exploiting the full potential—often because they are afraid of volatility.

Broadening the Opportunity Set

The International Monetary Fund forecasts that emerging-market (EM) economies’ share of purchasing-power-adjusted global economic activity will reach 54% by 2016. Yet, while exposures vary widely, policy allocations of just 5% to EM equities are typical. This is less than half the nearly 13% that emerging markets represent in the MSCI All Country World Index. 

Historically, stocks have provided the best way to participate in the long-term economic growth of these countries. But many investors are reluctant to increase their EM stock exposure as volatility remains much higher than in developed markets. 

But investors don’t have to limit themselves to stocks when seeking to profit from emerging markets. There are multiple potential beneficiaries of economic growth in these countries, including bonds and currencies—and even developed-market stocks (because some developed-market companies sell into emerging markets). These asset classes benefit from growth in different ways, giving investors greater diversification and the potential to reduce volatility. 

Using bonds to offset the volatility of stocks has only recently become a viable strategy in emerging markets. The EM bond universe is growing and maturing. It includes both sovereign and corporate bonds, denominated in either US dollars or local currency. 

These sectors all have different risk/return profiles, thus adding multiple sources of diversification. At an aggregate level, EM stocks and bonds exhibit greater correlation with each other than developed stocks and bonds, because of global investors’ tendency to treat EM stocks and bonds as one “risk asset”. However, at the country level, there is still substantial variation in correlation. 

Simply bolting together EM equity and debt portfolios can fail to capture the most attractive part of company capital structures. For example, if a company has strong cash flow and a solid balance sheet, its financial strength might make it appear attractive to both stock and bond investors. So a strategy that bolted together a stock manager with a bond manager would most likely result in a portfolio that held both the stock and bonds of the company. 

But if investors are in a position to make relative value judgments across a company’s capital structure, they can determine whether the stocks or bonds hold more value, and focus their allocation accordingly. For example, today we are seeing examples of strong EM companies trading as low as around four times earnings. In some cases we see much greater upside for stock investors if these companies merely meet their earnings expectations and see a modest increase in their earnings multiples. 

In summary, we believe that, by broadening the opportunity set, an unconstrained approach gives investors access to more and different asset classes, countries, currencies and securities than a stand-alone debt or equity portfolio does. Since it allows for greater flexibility to seek higher risk-adjusted returns and greater diversification to reduce portfolio volatility, we believe that this strategy provides investors with new ways to succeed in some of the world’s most exciting economies.

MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices, any securities or financial products. This report is not approved, reviewed or produced by MSCI.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio teams.

Emerging Market Investors Don't Have to Take Volatility Lying Down
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