Since the launch of the MSCI Emerging Markets Index in 2001, emerging market equities (EM) have rewarded investors with a per year excess return of over 4% above developed markets. The thesis for investing in EM is really quite simple: riskier, less transparent, less mature, and less followed markets should reward long-term investors with increased growth prospects and diversified sources of return. So if investing in EM provides benefits any rational investor would appreciate, why are many investors reluctant to allocate to EM within their portfolio? We find many investors look at the allocation as a standalone investment, and are dissuaded by the risks and potential for large draw-downs within this market. This view fails to fully appreciate the potential benefits of diversification that an EM allocation may provide. Thus, investors often leave a potentially attractive excess return opportunity and a source of diversified returns, sitting on the table, untapped.
This conversation is especially relevant now. It’s no secret that EM has struggled with the escalation of trade wars and a rising dollar. In fact, in 2018, EM lagged the developed world by almost 6%! While this difference in returns is quite significant, so too is the opportunity when looking at historical trends.
How to ante up in Emerging Markets
If the long-term return premium for EM is persistent and the entry point remains attractive, the question on how to approach the associated risks remains. Some investors are able to take a long-term view and bear the brunt of draw-downs in the asset class in order to participate in the upside when markets rebound. However, given the widespread under-allocation to EM within the portfolio of many of our clients, we believe most individual investors aren’t in this camp. For those who are skittish about the volatility of EM equities, minimum volatility investments might be a more palatable exposure to the asset class. Funds such as the iShares Edge MSCI Min Vol Emerging Markets ETF (EEMV), seek to track indices that aim to provide broad exposure to an asset class but in a manner designed to reduce risk.
True to its design, EEMV has historically provided investors with downside risk mitigation. In 2018, EEMV declined 58% less than that of broad EM as measured by the MSCI Emerging Markets Index. If we extend the analysis to a longer period of time, similar performance behaviors hold. Since its first full month of live performance in November of 2011, EEMV has exhibited a downside capture of only 78%, reduced volatility by over 23%, and dampened the maximum drawdown by 22%.
Anticipate risk: Rein in Emerging Markets
If one can potentially soften draw-downs, while also gaining exposure to a source of diversified returns, EM may become a much more attractive investment for many individual investors. Consequently, a minimum volatility strategy may help investors feel comfortable investing in a riskier asset class, while also helping them to remain invested through more challenging market environments. Importantly, for long-term investors, EM has yielded a positive return premium over time versus the developed world. EM also provides a differentiated source of return compared to other asset classes that can play an important diversification role within portfolios.
Recently, we have seen trade wars disrupt and pressure EM; however, we believe that much of the potential impact of these trade wars has already been priced in. That said, volatility may escalate or subside from here. Either way, we consider the EM asset class a longer term investment option that currently exhibits shorter-term opportunity. For those who want to be prepared for potential downside, while maintaining upside participation, an Emerging Market Minimum Volatility strategy, such as EEMV, may be worth considering.