Emerging market assets: Zoom out and re-focus
Emerging market assets well placed to outperform their developed world counterparts but too much attention is devoted to the short term. How should investors think about this part of the market from a strategic asset allocation perspective?
After years of underperformance, emerging market (EM) assets now look cheap and investor interest is growing. But how should investors think about an EM allocation? By exposure, EM equities are dominated by Asia and China in particular, a feature that is only set to grow following MSCI’s decision to include Chinese A-shares in their main benchmark index. Emerging market debt (EMD) has more balanced exposure. Within EMD, local EMD exposes investors to currency risk but is actually safer than others in terms of credit risk. Our paper explores these and other similarities and differences across the main EM asset classes.
We also answer a question on the minds of many investors today: how should I think about my strategy when investing in EM? Much EM commentary and research gets bogged down in short term noise. We take a step back and look at the medium to longer term outlook from a strategic asset allocation basis. We build up a profile for the outlook for returns and risk for the major EM asset classes and, importantly, consider how different portfolios of EM assets can allow investors to achieve different objectives. We find that local EMD is the most attractive in risk-adjusted terms, but this barely features in many investors’ portfolios. We argue that this should change. EM equities offer the highest return prospects but also the greatest risk and less “bang for your buck” than local EMD at present. Hard and corporate EMD lag some way behind.
There is no one, optimal way of investing in EM and investor specific risk and return requirements must be taken into account. The diversity of assets available offers a broad range of potential outcomes, which we outline in our paper. We find that investors with high required returns are likely to benefit from tilting towards higher equity exposure. For more moderate return objectives, larger allocations to local EMD make sense. A case can also be made for including hard and corporate EMD in an EM portfolio on diversification grounds, despite their being unattractive in isolation.
We also argue that breaking with tradition and carving out a specific allocation to EM assets can improve portfolio efficiency and allow investors to gain exposure to different sources of return than when investments are considered along individual asset class lines.