Two-pronged tactic mitigates risk

Investors can generate returns by blending emerging market debt and equities in their portfolios as the developing world is buttressed by steady growth, low debt and good valuations.

Emerging market equity and debt markets suffered from declines during the 2011 correction. Despite the majority of the problems emanating from the developed world, emerging market assets were sold off more heavily, as they were penalised for being perceived by the market as riskier assets.

Yet growth in emerging economies continues to be resilient amid the sovereign-debt turmoil in America and parts of Europe. Relative to developed markets, emerging markets have been supported by better fundamentals, including lower indebtedness. With the declines being the result of contagion from developed markets, emerging market assets, both debt and equity, are appealing relative to both the developed world and historical levels.

In volatile markets it is attractive to hold both equities and debt as this can reduce the systematic risk and the extreme outcomes that are typically found in emerging markets. A balanced approach will create a more stable, less volatile pattern of returns. This smoothing effect is further enhanced if one holds both value and growth equity strategies and hard and local currency debt strategies.

Since 1988, emerging market equities have experienced 11 drawdowns lasting at least three months and leaving them temporarily more than 20% down from their peak. These drawdowns are shorter and less severe if a blend is used. (Strategy continues below)

In the figure (below) we have used 50% MSCI Emerging Markets Index, 25% JPMorgan ELMI+ Index, 25% JPMorgan EMBI Global Diversified index and as you can see from a blend of 50% MSCI Emerging Markets, an equity index, and 25% JPMorgan Emerging Local Markets Plus and JPMorgan Emerging Market Bond Global Diversified, two key bond indices, returns have been greater since 1995 with a reduction in volatility.

”A balanced approach will create a more stable, less volatile pattern of returns”

Looking for value in emerging markets should defend well in times of uncertainty or crisis and outperform in a falling or flat environment. On the other hand, looking for growth in emerging markets – typically, focusing on capital expenditure – should outperform when companies in emerging economies are expanding capacity and stockmarkets are in an expansionary phase.

The emerging market debt component will normally be the most defensive strategy. Different managers will have different approaches to debt and income, but we prefer broad exposure to emerging markets sovereign and corporate debt and currency. The emerging market debt component of the strategy should offer a greater level of protection when markets decline, though they will also participate in any positive re-rating of emerging market countries.

To make these allocation decisions between the strategies, the first step in the process should be to assess the economic environment. Investors can consider several scenarios. A successful top down multi-strategy manager should seek to keep a portfolio exposed to appropriate factors driving the markets in context.

We are allocating to four main areas of the emerging markets: value equities, growth equities, debt and income.

Equity valuations are at particularly attractive levels when compared with the developed world. Emerging market equities still trade at a 16% discount to developed markets equities as a multiple of their earnings, leaving significant room for emerging markets to outperform if recession fears in the developed world abate and aggregate demand increases.

It is likely that equities are trading at discount valuations, so we are moderately increasing market exposure by shifting to an overweight allocation to equity versus fixed income. Within equity, we are shifting to an overweight allocation to the relative growth strategy versus the relative value strategy.

If Chinese growth stagnates or the Europe sovereign crisis worsens, defensive instruments would be needed. We would reduce exposure to the portfolio by reallocating from equity to fixed income and from growth to value within equity. The extent of the re-allocation would depend on the severity of the scenario. In general, we tend to change the risk in our allocation gradually, for example by moving into equity growth first and then into equity overall.

Investors should continue to monitor the debt crisis in Europe. Equity valuations are at attractive levels and within fixed income, fundamentals in many emerging market countries remain solid. We view the sell-off of the last quarter as an opportunity for entry, particularly in currencies, where we are most convinced the asset class will rise, notably in Asia.

Jai Jacob is a portfolio manager at Lazard Asset Management.