Emerging-market (EM) equities are far more turbulent than their developed-world peers. But there are several things investors can do to capture the attractive return potential while reducing volatility. Staying active is the lynchpin for success.
Economic progress and structural reforms over the past 20 years have reduced some volatility in many EM countries. However, EM stock markets are still more volatile than their developed-market (DM) counterparts. And single-stock EM volatility tends to spike more sharply in times of crisis. Our research shows that since 1996, the chance of losing more than 30% of an investment in a single stock was far more common in EM than in DM. In declines of 30% or more, the average loss was also higher for EM than for DM.
The Problem with Indexing
Buying the index might seem like a low-risk approach. However, the four riskiest emerging-market countries over the past 20 years—Russia, Indonesia, South Korea and Brazil (Display)—represented over 35% of the EM Index’s market capitalization at the beginning of this year. By being concentrated in the most volatile set of countries, a passive index will take on substantial excess risk. We believe investors can proactively mitigate the risks with these five active principles in mind.
Don’t Be Too Quick to Reload into Losers—In emerging markets, price momentum is very powerful. Winning stocks typically stay winners for longer than in DM, and losers keep on losing for longer too. So when a money-losing stock faces significant headwinds, we think investors should think twice before reloading—and should be quicker to consider selling a position.
Invest in Less Volatile Companies—Companies with stable cash flows, good capital stewardship and/or lower sensitivity to the business cycle are good targets in emerging markets. Our research shows that the lowest-beta quintile of EM stocks was three percentage points less likely to decline by more than 30% than was the EM market as a whole. This resulted in a meaningful pickup in long-term returns.
Stocks of such companies might not do as well when markets are exuberant. However, they have tended to outperform the market over full market cycles. We call this gaining more by losing less.
Hedge Currency Risk for Times of Stress—Currency is an important component of equity returns for nondomestic investors. Our research found a negligible relationship between the strongest-performing EM equity markets and their currencies since 1997, during typical market conditions. However, in extreme market volatility, the linkage between a country’s currency as measured by the real effective exchange rate (REER) and its equity returns tends to increase significantly (Display). So managing the risk of sharp swings in currency should always be considered by emerging-market equity managers.
Diversification Matters More in EM—Unexpected—and often unpredictable—events happen far more frequently in the developing world. In developed markets, we generally believe you need at least 40 stocks to diversify away 95% of the risk of individual stocks. However, because of the higher levels of single-stock volatility and higher correlations between those stocks in EM, we need nearly twice as many to provide the same level of risk reduction.
Following the largest names in the index can lead to unintended concentrations in specific countries, sectors, or styles. For example, if we just bought the 75 largest stocks in emerging markets, over 65% of the portfolio would be allocated to just four countries, with nearly 70% to financials, technology and energy. Don’t shy away from taking high active risk, but combine it with prudent diversification.
Holistically Combine Stocks and Bonds—Think beyond equities when considering diversification. Combining EM stocks, bonds and currencies, managed in an active, unconstrained and integrated strategy can generate returns that are similar to those of an EM stock-only strategy, but with much less volatility. It also provides more flexibility than a stand-alone equity or debt portfolio to seek higher risk-adjusted returns.
Risk control is a critical component in managing an EM equity portfolio. Because of the higher possibility of loss, we believe that EM investors should deploy a systematic approach, which could also enable them to potentially compound more of their gains over the long term.
This blog was originally published in InstitutionalInvestor.com.
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.