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By Morgan Harting A midyear sell-off in emerging-market stocks highlighted the challenges investors face in volatile times. We think a flexible approach that spans the asset classes can help. Equities dropped by about 25% between April and August, and volatility spiked to levels not seen since the mid-2013 “taper tantrum.” The cause: investors fretted about slowing Chinese growth, weaker commodity prices and looming US Federal Reserve rate hikes. It was particularly tough for passive equity investors whose exposure was concentrated in the BRIC countries – Brazil, Russia, India and China. Don’t Pay for Beta in Emerging Markets This experience seemed to reinforce the notion that investors shouldn’t “pay for beta,” particularly in emerging markets. Passive equity strategies in that arena can be as much as 50% more volatile than in developed markets. The added return needed to justify a passive equity allocation requires a lot of conviction – or disregard for higher volatility. The good news is that emerging markets are still pretty inefficient. Active managers can add value by generating higher returns to justify higher risk, or by reducing the risk in passive strategies. We think the flexibility to tap multiple asset classes in one portfolio – including bonds – can be effective. It’s a compelling way to get more active, seeking to dampen volatility and improve risk-adjusted returns. Episodes like the taper tantrum – a global sell-off across asset classes – can disrupt things. But we think those are the exception, not the rule, in cross-asset diversification. In the recent downturn, multi-asset strategies did indeed outperform passive broad-market equity strategies. Multi-Asset: Newer to Emerging Markets Developed-market multi-asset strategies have been around for a while, but the emerging-market versions are relative newcomers. Many investors still prefer asset-class “pure” emerging-market strategies: all equity or all debt. As the thinking goes, it’s better for managers to focus on asset-class expertise than venture into other areas. We think high volatility in passive emerging-market equity changes the argument. Investors should use every tool to reduce risk and preserve returns. Multi-asset emerging-market approaches offer a tool that controls volatility better than just moving to lower-volatility stocks. The average volatility of emerging-market stocks? It’s 22% over the past decade. For bonds, it’s less than 5%, and with much less downside risk. The recent sell-off in emerging markets has made the volatility and downside risk-reduction benefits more evident, as these managers have outperformed meaningfully. The Case for Crossing Asset-Class Boundaries Granted, some active managers are very skilled in individual asset classes. But no matter which emerging-market asset class you’re in, the main return driver is broad emerging-market risk. The proof is in the return patterns. Over the past decade, the correlation between emerging-market stocks and bonds has been 0.7, much higher than the 0.1 between developed-market equity and debt. 1 With so many common return drivers among emerging asset classes, it seems to make more sense to manage emerging-market equity and debt together in a single portfolio than it does with developed markets. After all, the correlation between US and Japanese stocks is just 0.5, 2 but it’s hardly controversial anymore to suggest one manager for a global equity portfolio. Many investors want to take part in emerging-market growth and may see today’s attractive valuations as an enticing entry point. But they also might question whether it’s really worth it after factoring risk into the equation. We think multi-asset approaches offer a way to reduce some of that risk. Morgan C. Harting, CFA, CAIA Portfolio Manager – Multi-Asset Solutions 1,2 For the 10-year period ending September 25, 2015. Emerging-market stocks represented by the MSCI Emerging Markets Index; emerging-market bonds by the J.P. Morgan EMBI Global; US and Japanese stocks by their respective MSCI indices. Disclaimer: MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Scalper1 News
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