Jan 25, 2024
The reality is that EM equities are now less volatile than developed market equities. This gives renewed impetus to the case for emerging markets as a diversifying exposure which can deliver attractive risk-adjusted returns.
The term ‘emerging markets’ was coined by IFC economist Antoine van Agtmael in 1981. Since then, key drivers for these markets have centred on two factors: the potential for higher returns driven by superior economic growth and the potential for risk reduction through diversification.
For more than a decade, the performance of EM equities has fallen short of investor expectations. Ninety One's paper ‘In the Crossfire’ analysed the root causes behind a disappointing decade and re-examined the structural proposition for EM equity allocations.
Following publication, it became clear that diversification remained a point of scrutiny. Many investors lack conviction in the diversification properties of EM equities.
This led us to investigate whether stocks in developing countries really do have the potential to diversify returns and reduce risk in a global investment portfolio.
Arguments against tend to centre around the these three perceptions:
We use these refrains to structure this analysis. The results are provocative for asset owners. EM characteristics include a lower beta to DM equities outside of crises, lower volatility in recent years and lower correlations with DM equities than most asset classes of similar size.
During crises, the volatility or risk associated with EM equities tends to be higher than that of developed market equities, probably because of the interaction between financial crises and economic crises in EMs. When risk aversion sets in, the dollar tends to appreciate, leading to capital flight from EMs. This supports the notion that EM equities inherently carry more risk compared to their DM counterparts. Meanwhile, there is always one crisis or conflict brewing in the developing world, the headlines are rarely positive.
Yet the reality is more complex than the perception of risk. By some measures, EM equity assets have become less risky than DM assets, and the notion that EM equities are little more than a leveraged bet on the most cyclical parts of the global economy is now out of date.
Start by comparing the beta of EM equities to DM equities. Examining on rolling 3-year time frame, the beta of the MSCI Emerging Markets index to its developed market counterpart has consistently remained below one throughout almost the entire history of the index. It is only during the period that includes the GFC that the sensitivity of EM equity returns to DM equity markets clearly exceeded one. One way of understanding this chart is that under normal conditions, EMs tend to be less risky than people think. However, during significant crises, the potential losses in EM can be greater.
Figure 1: Emerging market vs. developed market beta
Source: Bloomberg, MSCI where EM is represented by MSCI Emerging Markets and DM by MSCI World. Calculations by Ninety One, as at 31 December 2023.
In addition, the standalone risk profile of EM equities has changed dramatically. As emerging economies and financial markets have matured, the volatility of their equity markets have shown a steady decline. In fact, in recent years, EM equity volatility has fallen consistently and is now lower than that of developed markets.1
Figure 2: Emerging market vs. developed market volatility
Source: Bloomberg, MSCI where EM is represented by MSCI Emerging Markets (Local) and DM by MSCI World (Local). Calculations by Ninety One, as at 31 December 2023.
Next, we can look at correlations. EMs tend to have lower correlations with other equity markets, usually ranging between 50-60%. In comparison, US and European indices show higher correlations, typically around 70-80%. Japan, like emerging markets, has also proven to be a strong diversifier, with correlation characteristics in line with emerging markets.
That matters because the risk of EM assets in a given portfolio requires making a judgment on the total portfolio. As Harry Markowitz2 showed in the 1950s, a portfolio’s risk is not solely determined by the average riskiness of its individual assets, but rather by the degree to which the returns on those assets are correlated. In other words, investors don’t need every asset in the portfolio to be lower risk to effectively mitigate the overall risk. So as a starting point, the question of EM risk should be ‘risky to whom’?
We know, for instance, that risk-adjusted returns of EM assets in euros are typically higher than those in dollars given existing correlations of EM assets to euros and dollars. Those lower correlations create the conditions for higher risk-adjusted returns in portfolios through the mechanism of rebalancing.
After examining these portfolio risk metrics, where does this leave investors trying to understand the risk of EM assets relative to DM assets? As discussed earlier, EM equities typically exhibit lower beta values, except during crises, and have seen a declining trend in volatility. Correlations are lower than equivalent assets. In essence this translates to relatively lower standard deviation of returns but with a more negatively skewed and fatter-tailed distribution compared to equities in developed markets.
In other words, in most conditions, emerging markets demonstrably have returns with less volatility when compared with developed markets. However, the tails are fatter. Returns are more likely to have more extreme events, both positive and negative, in their distribution. If the conventional wisdom is “EM is riskier than DM,” the picture is more complex. For investors, it is clear that emerging market equities have some useful diversification properties for advanced economy investors. Reputation and reality have diverged substantially, and that is where the opportunity lies.
1 This chart is calculated using local currency return across both markets. Measuring returns in a common currency such as the US dollar makes some differences to the levels of these series but all of the specific points made in the text hold in both local currency and US dollar terms.
2 Harry Markowitz was best known for his pioneering work in modern portfolio theory, studying the effects of asset risk, return, correlation and diversification on probable investment portfolio returns.
In summary, diversification serves as a powerful tool for risk reduction in investment portfolios. EMs possess attributes that make them conducive to diversification within DM portfolios. These include a lower beta to DM equities outside of crises, reduced volatility compared to DM equities in recent years, and lower correlations with DM equities than most asset classes of a similar size.
However, it’s important to note that integrating EM equities into DM portfolios requires a strong risk management framework and a keen awareness of the macro drivers of emerging markets to mitigate potential risks.
While US investors may exhibit a ‘home bias’, the potential benefits of diversification across most equity markets could outweigh any such bias.
Moreover, the underperformance of EMs over the last decade can be attributed to specific factors that are expected to evolve differently in the coming decade. It is also crucial to differentiate between diversification and hedging. Diversification aims to enhance risk-return outcomes over time, while hedging is about downside protection in a crisis. Consequently, focusing solely on short-term market sell-offs neglects the broader diversifying and risk-reducing benefits that EM equities can offer under all other market conditions.
In general, emerging market equities are not unduly risky relative to other equity investments in most scenarios. Nevertheless, special attention should be paid to their fragility during significant crises.
Indices. Indices are shown for illustrative purposes only, are unmanaged and do not take into account market conditions or the costs associated with investing. Further, the manager’s strategy may deploy investment techniques and instruments not used to generate Index performance. For this reason, the performance of the manager and the Indices are not directly comparable.
If applicable MSCI data is sourced from MSCI Inc. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.