Rethinking emerging market equity exposure

Stagnant growth and low interest rates in developed markets are prompting institutional investors to re-examine their emerging market exposures.

Allocations to emerging markets have grown in institutional equity portfolios, providing additive returns over the past 10 years and benchmark outperformance relative to developed market counterparts. However, the outperformance has come with periods of significant drawdowns and volatility. For pension funds with regular payout liabilities, the risk of exposure to emerging markets' magnified volatility can be a concern. The MSCI Emerging Market index has remained under water for significant periods of time, and although it usually rebounds, persistent choppiness can make it difficult for pension funds to manage their funding ratios. Further, investors should remember that economic growth is not a sufficient condition for index appreciation or developed market decoupling.

These factors need not deter investors from seeking emerging market exposure. Rather, complementing a long-only allocation to emerging markets with a tactically hedged long/short strategy might keep returns within a “warning track” range, while also providing attractive long-term returns. A “warning track” is a conceptual span of potential returns in which hedging and active shorting for alpha seek to truncate downward shocks.

Additionally, actively changing mandates can be especially useful during market dislocations: in many of those scenarios, the proverbial baby and bathwater are thrown out together, creating opportunities for long-term investors who can step in to take advantage of value created from dislocations. Over time, emerging market hedge funds substantially outperform broader emerging market indexes, despite the cost of hedging, due to less frequent, less severe negative shocks (so returns may compound). Most importantly under this investing approach, decreased volatility can be more than compensated for by longer-term returns.

Relative to developed markets, emerging markets have more volatility, greater dispersion and less transparency. For long-only, benchmark-based emerging market allocations, these features present challenges. From January 1994 (when hedge fund data became available) through March 2012, the MSCI Emerging Market index lost more than 10% in a single month a full 15 times. In contrast, the DJCS Emerging Market Hedge Fund index broke that barrier just twice. The risk of left tails in the DJCS Emerging Market Hedge Fund index can also be addressed by hiring managers that maintain lower market sensitivity than an average index constituent manager.

We believe an improved approach to emerging markets is to invest along a continuum of both long-only, beta-based exposure and long/short, alpha-based hedge fund exposure.

The portion comprising hedge funds should have two main components:

  • First is the “core”, which includes managers with a broad opportunity set and extensive, cross-market experience. They invest across capital structures, countries and regions, with opportunism not tied to where the companies are listed. Global flexibility allows their optimization of investment theses.
  • The second component is the “satellite” manager group of locally based managers that only invest within their local emerging market country. They focus on off-index and lower market-capitalization companies normally overlooked by a global perspective. Companies in this space often have idiosyncratic biases to local consumption-based growth, where greater dispersion provides wider potential alpha capture. Additionally, whereas traditional emerging market exposures often track index biases (for example, the commodities-overweight Bovespa index), “satellite” managers may provide a purer play that relies on the domestic consumer economy (and is less affected by, say, China's industrial growth).

Both “core” and “satellite” managers also seek to capitalize on failures in emerging markets. With the heavy inflow of capital, there are situations in which unworthy firms are awarded capital simply because of their emerging market domicile. These cases could provide attractive shorting opportunities. All together, “core” and “satellite” managers allow the investor to tap into a broad opportunity set on a hedged basis.

As institutions rethink the structure of their exposure to emerging markets, we feel it is important to consider complementing existing long-only mandates with hedged mandates. The mandates can be benchmark-agnostic, and can add value by reducing volatility and introducing new sources of alpha through domestic, stock-specific opportunities.

Alper Ince is a partner, managing director and the sector specialist responsible for the management of long/short equity hedge fund managers in the various PAAMCO portfolios.