Emerging Markets Investing

By M. Isi Eromosele

While the benefits of investing in emerging markets (EM) has been well articulated: higher expected growth rates, improving macroeconomic fundamentals, favorable demographics and competitive cost structures, investors still grapple with the best way to achieve exposure to emerging markets.

Investing in emerging market equities benchmarked against the MSCI EM Index has been one of the most popular approaches, though EM equities have traditionally exhibited high volatility.

Over the past decade, U.S. dollar-denominated emerging market bonds have also secured a strategic allocation in the portfolios of many global investors. More recently, there has been growing interest in investing in the local currency debt of emerging markets, as local fixed income markets have deepened. Emerging market currencies have been another way to gain exposure.

Selectively combining country-specific exposures to EM bond, equity and currency markets might address volatility concerns with equity-only approaches and potentially enhance return opportunities.

A Holistic, Integrated Emerging Markets Approach

A total emerging markets approach is well suited to the distinctive risks and opportunities that are characteristic of emerging markets investing. In emerging markets, country-level risk is a dominant risk factor affecting the behavior of all asset classes, whether it is equities, bonds or currencies.

Country-level risk is generally high in emerging markets. These country-level risks are not necessarily geopolitical. They may reflect high levels of regulatory, political, social or macroeconomic uncertainty. As a result, investors in emerging markets might be well served by diversifying these country-level risks as much as they can.

One way of achieving a higher degree of country diversification is by expanding the traditional opportunity set; in other words, going beyond emerging market equities and looking at bonds and currencies. This is because the country universes of EM equities and fixed income only partially overlap.

Rather than allocating a portion of a portfolio to emerging market equities and a portion to emerging market fixed income, an integrated approach provides a better way of mitigating the emerging market risk generally associated with equity-only portfolios.

An effective approach would be to look at all countries individually and attempt to select what you consider to be the best equity and fixed income exposures, seeking to avoid any excessive country concentration.

Mitigating Common Risks

The holistic combined approach is an attractive option for investors contemplating an increase in exposure to emerging markets but who are concerned about the high volatility and concentration of traditional emerging markets equity products.

The fixed income exposure of the strategy may dampen the volatility associated with exclusive exposure to emerging market equities. Historical data have shown that including an exposure to EM fixed income (25 percent EM local bonds, 25 percent EM U.S. dollar bonds) would have enhanced the returns of an emerging markets portfolio over the last 17 years, which is the longest period for which the data are available, spanning up and down phases of global market cycles.

Managing An Integrated Approach

This integrated investment process should include a global macro outlook and views of individual countries. For each emerging market that the strategy invests in, you should ask four questions.

• First, is there value in equities? Look at the P/E ratio and free cash flow yields, returns on capital, growth prospects and competitive dynamics.
• Second, is there value in the currency forward? This requires understanding the balance of payments situation, the Central Bank’s priorities, the country’s monetary policy, level of sovereign risk, the overall global market and market technicals.
• Third, one should look at whether there is value in the currency-hedged bond. Here you look at inflation expectations, policy rate forecasts, sovereign risk as well as the global environment and, again, market technicals.
• Finally, one should ask whether spreads on U.S. dollar denominated bonds compensate for the unexpected losses, uncertainty and potential illiquidity. Here, too, you do a thorough assessment of sovereign risk, taking a close look at external and internal balances, liquidity and structural variables such as political and institutional risk.

A more traditional fund-of-funds approach (allocating between separate EM equity and fixed income sleeves) does not address these questions aimed at identifying the most attractive opportunities on a country-by-country basis.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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