by Russ Koesterich, Portfolio Manager, iShares
Thirty years ago, financial shocks mainly originated in emerging markets. Today, as we are all too well aware, those financial shocks are originating closer to home, in the developed world.
Given today’s volatile world, it may be time for investors to adopt a more nuanced approach to investing in emerging markets. Rather than using the traditional frameworks — such as emerging markets versus developed markets — I’m advocating that investors consider creating their international allocation on a country or regional basis. Here are two reasons why:
1.) Traditional frameworks are less relevant than they used to be. There are increasing differences now between how individual emerging market countries are performing, what their prospects are and where they are in the economic cycle. The same also applies for developed market economies.
As a result, it’s possible that common groupings of countries don’t represent the views investors want to express. This is true for both broad emerging market and developed market groupings as well as for traditional smaller groupings.
Take the BRIC, for instance. It’s the acronym that applies to the emerging market countries of Brazil, Russia, India and China, and to indices tracking these economies. While it may be a great acronym, it no longer represents a homogenous group of countries that are all in a similar stage of economic development. Today, there are significant differences among the BRIC countries, especially regarding how they are combating inflation. As a result, if you hold different views of the countries (say, if you love Brazil and hate Russia) a BRIC fund may be a bad way to implement your view.
In other words, a more granular implementation scheme can potentially provide investors with additional flexibility to implement tactical views or to more accurately tilt a portfolio when circumstances warrant.
2.) Potential for improved risk-adjusted-returns. According to my team’s research, there is some evidence that the added flexibility associated with a granular approach may in turn potentially result in improved risk-adjusted-returns.
In an experiment, we used the MSCI USA Index, the MSCI All Country World ex-US Index and the MSCI Emerging Markets Index to build an investment portfolio targeting the same risk level as the MSCI All Country World Index, or ACWI. These three indexes can be used to create ACWI. In our experiment, we rebalanced the mix of the three indices monthly so that the expected risk of the granular portfolio targeted the same risk as ACWI.
While there’s no guarantee our experiment would match what would happen in real world investing, our granular portfolio did deliver additional return over our testing period of 1990-2010. In addition, when we tested a riskier granular portfolio versus the global index, we found that the riskier portfolio could potentially deliver even more additional return.
To be sure, whether investors should focus their equity allocation at the global, regional, or country level will certainly depend on if they want to express tactical views. Still, I believe investing on a country or regional basis could help investors potentially gain both flexibility and better risk-adjusted returns.
Past performance does not guarantee future results.
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.
