Emerging Markets: Get the Mix Right

mix tape cassetteFor many investors, emerging market stocks have typically provided the best way to capture the potential of some of the world’s fastest-growing economies. But higher volatility than what usually occurs in developed markets is often a deterrent to increasing emerging-market stock exposure. The good news is that emerging markets offer more than just stocks. Bonds and currencies can provide multiple sources of return potential and more ways to mitigate risk. An investor could invest in these asset classes separately, but integrating them in one dynamically managed portfolio can generate much better risk/return potential than a stock-only strategy.

Bonds Offer Big Diversification Benefits

The emerging-market bond universe is growing and maturing. For example, roughly 55% of the JP Morgan EMBI Global Index is now rated investment grade, whereas a decade ago, most bonds were rated at the lower end of speculative grade. These bonds now behave like developed-market investment-grade corporate bonds, making them more effective than non-investment-grade bonds in offsetting the volatility of emerging-market stocks. Yet despite their quality and greater downside protection, emerging bonds are highly correlated with emerging stocks, underscoring the benefits of managing them together in a single, integrated portfolio.

Active currency management is another “lever” for a multi-asset strategy. A substantial portion of both the return and the risk of investing in emerging markets derive from currency exposure. Disaggregating the currency selection decision from the stock and bond selection decision creates new opportunities to improve portfolio efficiency. For example, you could invest in a Turkish exporting company in expectation that its competitiveness will improve as a result of a weaker Turkish lira, while simultaneously shorting the lira so that the currency’s depreciation won’t impact the principal value of the stock.

A Multi-Asset Strategy

Single-asset class managers don’t always see the bigger picture. For example, an emerging market bond manager will likely own some Venezuelan bonds, despite their tremendous political and economic risk, because the country represents a large proportion of the bond benchmark’s yield spread. Yet many emerging-market stock investments appear to offer similarly high return potential with lower levels of risk.

Simply bolting together emerging equity and debt portfolios would fail to capture the most attractive part of company capital structures when an issuer has marketable stocks and bonds. Take Petrobras, a Brazilian energy company with a strong cash flow and a solid balance sheet. Its fundamentals are attractive, and the company has a large weight in both the equity and debt benchmarks, so it would appeal to both stock and bond investors, and would probably be found in a strategy that bolted together a stock manager with a bond manager. But with an integrated multi-asset strategy, the focus could be on the part of the capital structure with the most attractive risk-adjusted return expectations. In this case, the stock would have been recently more attractive because the company’s strong balance sheet and low equity valuation suggest limited downside potential for the shares.

More Countries, More Opportunities

An unconstrained multi-asset strategy also allows a manager to invest in more emerging market countries, which are often absent from major stock indices or bond indices. For example, Taiwan and South Korea are among the larger country components of the emerging market stock benchmarks but are not included in some emerging market bond benchmarks. China accounts for 17% of the stock benchmark but just 1% of the bond benchmark. And some emerging markets are represented only in the bond market benchmark (such as Venezuela, Lebanon, Panama and Ukraine).

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. With greater flexibility to seek higher risk-adjusted returns and greater diversification to reduce portfolio volatility, a multi-asset strategy provides investors with new ways to win in some of the world’s most exciting economies.

Morgan Harting is Senior Portfolio Manager, AllianceBernstein.