A common complaint of investors is that while they relish the idea of emerging markets equities, the volatility is an equal offset to the opportunity. Given the generally greater negative volatility of emerging markets equities, this sentiment is understandable. Over time, advancement in emerging markets countries will come from greater self-sufficiency, including the growth of the middle class. This transition will create opportunity; participation doesn’t require wholesale acceptance of volatility, which can be typical in emerging markets equities. By improving upon the standard approach to investing in emerging markets, it’s possible to provide access to the long-term emerging markets story, as well as a more consistent emerging market equity experience.
Minimizing drawdown is an important part of this approach. Simply put, a portfolio that loses less in down markets has less ground to make up in good markets. There is strong empirical evidence from developed markets that low-risk stocks (i.e., low leverage, high profitability, etc.) outperform high-risk stocks over time. The same can be seen in emerging market stocks over the last decade. There are several tenets of investor psychology that may explain why this anomaly persists. Nonetheless, a high-quality stock opportunity has historically existed for investors to exploit.
The governance question
There are several other important considerations when constructing a lower-risk emerging market equity portfolio. The first is geographic diversification. Variations in both secular and cyclical factors lead to market environments that will favour a given country at one point and not at another. Therefore, geographic concentration can add to portfolio volatility and should be minimized.
Second, emerging markets have historically been subject to the economic prospects of the developed world. This is particularly true of those companies and countries that are more exposed to global factors such as commodity prices. An increased focus on more domestic-oriented sectors such as consumer and healthcare can help mitigate these risks.
Finally, one shouldn’t ignore the impact that corporate governance can have on equity performance. Adverse corporate governance events can occur in any market, but emerging markets are arguably more susceptible given their less developed legal structure. Focusing on companies with a strong history of corporate governance can help prevent the permanent loss of capital that can result from such events.
Brian Drainville, CFA, is institutional portfolio manager, Pyramis Global Advisors