More Emerging Markets, Less Volatility?

Sharon Fay

The steep drop in returns for emerging-market stocks this year—even worse than the drop for  developed-market stocks—provides a useful reminder that the asset class remains risky, despite its many attractions.

How can investors capture the strong economic and earnings growth in emerging markets without taking on so much risk? I see two ways: One is by investing in developed-market stocks that benefit from rapid demand growth in emerging markets. The second, perhaps less familiar, strategy, is a multi-asset approach, as described below by my colleague Morgan Harting.

Is there a way to capture the strong economic and earnings growth in emerging-market growth without betting the ranch on such volatile securities?

Our research indicates that a portfolio that takes an active, unconstrained and integrated approach to investing in emerging-market stocks, bonds and currencies has the potential to reap stock-like returns, with less volatility.

Using bonds to offset the volatility of stocks is a basic risk-management strategy in developed-market portfolios, but it has recently become viable for emerging markets, too, as bond markets there have matured. The emerging-market bond universe includes both sovereign and corporate bonds, denominated in both US dollars and local currencies. These broad sectors have different risk/return profiles, providing multiple sources of diversification.

Our research suggests that the downside protection and volatility reduction from adding emerging-market bonds to an emerging-market stock portfolio are likely to be significant, but less powerful than adding developed-market bonds to a developed-market portfolio. That’s because in aggregate, the stock/bond correlation in emerging markets is higher than in developed markets. (Within individual countries, there is still substantial variation in stock correlations to bonds.)

Why? Global investors tend to treat emerging-market stocks and bonds as one “risk asset.” As a result, emerging-market bonds in aggregate may sometimes fall with emerging-market stocks, but they generally don’t fall nearly as far (Display).

Bonds Dampen Stock Risk and Provide Return PotentialOn the other hand, emerging-market bonds’ relatively high correlation with emerging-market stocks—and the bonds’ own significant return potential—imply that combining the two asset classes shouldn’t constrain upside potential as much as it does in developed-market portfolios.

Our research also suggests that actively managing emerging-markets stocks, bonds and currencies in an integrated and unconstrained strategy can increase the sources of diversification and uncover cross-asset strategies. Emerging markets are still relatively inefficient markets, which is precisely what makes them ripe for an active management approach.

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.

Sharon Fay is Head of Equities and Morgan Harting is Co-Team Leader of Emerging Markets Multi-Asset Portfolios, both at AllianceBernstein. 

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