Commentary: Emerging markets without the volatility

A steady 28% gain in the MSCI Emerging Markets index year-to-date, has many investors rethinking their exposure to the asset class. At a time when developed markets are thought to be entering the later stages of the current cycle — and as the S&P 500 index forward price-earnings ratio exceeds 18x projected earnings — emerging markets equities would seem to provide an obvious counterbalance for fundamental investors seeking diversification and value otherwise hard to find.

The difficulty, of course, remains the volatility inherent to the asset class. Even as the developed markets are just as susceptible to black swan events, the surprises in emerging markets are more common and often more pronounced. Investors were reminded of this in mid-May when Brazil's Ibovespa index fell 9% upon news that the country's president was being charged with bribery and obstruction of justice related to JBS SA's unfolding political-kickback scandal.

Put simply, actively managed liquid alternatives strategies are allowing investors who normally would not be able to stomach the uncertainty of emerging markets to potentially capture alpha from both up and down market moves. Moreover, in an era in which globalization and an accommodative monetary policy have large-cap stocks moving in lockstep across developed economies, emerging markets variable long/short funds provide an uncorrelated source of returns and protect against — while also potentially profiting from — the valuation, earnings and balance sheet risks common to emerging markets companies.

To be sure, the many draws that first attracted investors are just as evident today. It was around early 2000, for instance, that Goldman Sachs' seminal report on the BRICs familiarized the broader investment community with the compelling macro drivers fueling growth across Brazil, Russia, India and China. (More recently, Jim O'Neill, who coined "BRICs," has expanded this group to include the MINT economies, comprising Mexico, Indonesia, Nigeria and Turkey.)

In short, the macro case can be summed up by the disparity that still exists between developing economies' contribution to global GDP growth, representing 58% on a purchasing power parity basis, and the relatively scant 11% share that emerging markets stocks contribute to the total capitalization of the world's equity markets, based on data from the International Monetary Fund and MSCI Inc. Not to be overlooked is the steady expansion, as emerging market economies represented just 36% of total GDP growth in 1990, based on the same data, a percentage that has only gravitated higher in the nearly three decades since. From a demographic perspective, the projected working-age population and anticipated productivity growth would also seem to favor most emerging markets economies and should provide a tailwind for long-term investors.

To be sure, most market watchers do recognize the appeal of emerging markets stocks, although the avenues to invest in these regions are largely confined to passively managed exchange-traded funds and index funds or actively managed, name-brand mutual funds. It's worth noting many of the active strategies from the largest fund families may have assets under management of between $30 billion and $50 billion, imparting diseconomies of scale that tend to confine portfolio managers to all but the largest emerging markets names. This is why so many long-only funds tend to hug the benchmarks and fail to capture the idiosyncratic risk that should characterize emerging markets exposures.

In the past, long/short strategies targeting emerging markets were only available to institutional investors that had the bandwidth and capabilities to cobble together a broadly diversified allocation through backing several local or specialized hedge funds. The caveat was that these limited partnership fund commitments often required lengthy lockups and higher fees. Moreover, these options often introduced concentration risk through focused portfolios targeting a specific geography or region that may be overly exposed to a specific currency, commodity or trade-related risk.

Emerging markets investing is not without its share of challenges, especially when put into the 1940 Act fund format, which is why emerging markets long/short strategies are only now becoming more accessible. Just covering an investment universe of as many as 3,500 names — across currencies and regulatory regimes — requires a robust and consistent quantitative front end. This is particularly the case as ongoing improvements in transparency and governance across most developing countries has tilted the playing field from local managers that enjoyed an informational advantage to more advanced strategies bringing an analytical edge.

The technical challenges to execute a long/short strategy can be even more daunting. Certain jurisdictions, for instance, may outright ban trading on margin or require a seat on the exchange to physically short a stock. To overcome these hurdles requires a sophisticated trading operation, relationships with multiple prime brokers, robust counter-party monitoring systems and deep custodial relationships, all prerequisites for fund managers intending to utilize contract for differences equity swaps.

But these issues, while challenging, also support the inefficiency that makes the emerging markets so appealing for fundamentally driven strategies. Moreover, passive products have given rise to market-timing tendencies in which ETF investors move in and out of regions on a whim, often based on intuition or, sometimes, false signals ahead of macro events. This underscores why it's so important to maintain discipline around risk management (be it position-size limits or portfolio diversification), although it also speaks to the appeal for bottom-up, actively managed strategies that can discern the more qualitative factors supporting earnings growth and multiple expansion.

Industry veterans probably recognize similarities between the emerging markets today and European stocks of the mid-1990s, which proved to be a boon for fundamental, value-focused investors ahead of the euro's introduction. We see a similar opportunity set for emerging markets investors today; the difference is that variable long/short funds can moderate the volatility to make emerging markets exposure far more accessible for both institutional and retail investors, whether it's part of an alternatives allocation or merely complements existing international holdings.

Paul Korngiebel is the lead portfolio manager on the emerging markets long/short equity strategy of Boston Partners Global Investors Inc., based in Boston.​ This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.