To what extent can an investor enjoy the growth of a select pick of emerging market companies, while taking methodical steps to avoid as many unrewarded risks as possible? Kim Catechis, head of emerging markets at Martin Currie, gives his take on the challenge.
The size of an investor’s allocation to emerging market (EM) equities is tempered by their willingness to accept higher volatility than what they perceive is prevailing in developed nations, in return for higher growth.
Patience is required to ride out such volatility, especially if an investor’s EM allocation forms a significant part of their assets. To assist, a skilled manager should balance risks accordingly, to mitigate the number of periods the portfolio has drawdowns larger than the market.
Such balance is significant as any portfolio of EM companies picked for their likelihood of stronger sustainable growth, higher return on earnings and strong balance sheets, will still come with their own unique mix of market impacted risk factors.
So, having diversity in the mix of your portfolio is important. However, don’t assume the wide disparity of outcomes across the 24 countries and 846 companies that make up the MSCI Emerging Markets Index give instant diversification. Yes, the different countries are moving at different speeds to towards developed status, have different economic and population drivers and may have very different political frameworks, but the correlations between countries and select sectors in those countries can sometimes be high.
The allure of emerging markets
Source: International Monetary Fund. Gross domestic product, constant prices, percent change, April 2017 report showing estimated projection data.
Such top-down factors can be mitigated by calculating if the specific risks companies face; such as country, sector, currency or commodity, are sufficiently compensated when measuring the return expectations for individual stocks.
We approach this by first picking an opportunity set of stocks of around twice the size of the final portfolio. This allows us to choose a stock selection that reduces over-sized factor risks.
This can ensure the portfolio has enough diverse characteristics to move in a similar direction to the index – but to beat the index in the long-term through positive stock alpha. This beta neutral positioning contrasts an aggressive beta positioned portfolio that will rise higher in a market rally, but fall further in a downturn, or a defensive (low beta) portfolio that will not fully capture rises in strong growth markets.
To help this process, we seek to minimise non-validated thinking by a three-step process.
Firstly, we favour a large team of experienced EM professionals with a flat structure, whose voice and diversity of thought is valued equally.
We seek unanimous approval from this team for each stock pick, when selecting an opportunity set of companies from which to build a portfolio. This forces all the issues around a stock, that might otherwise be latent, on to the table.
Lastly, while it is common in the investment industry to reward team members for the performance of the stock picks from the country or sector they research and specialise in, in our team we favour rewarding each team member according to the performance of the overall portfolio regardless of which stocks each analyst contributed to the final portfolio. This focuses the minds of the team on the process of getting the opportunity set right and ultimately the end goal, rather than their personal gain. We believe it is the best way to align people.
Investors can lose out if the return drivers of a portfolio of emerging markets stocks picked from a bottom-up research process are over-ridden by a high sensitivity to macro-economic and other top-down factors. A portfolio carefully chosen for its calculated spread of risk can mitigate the impact of these top-down factors. This approach is one of the ways an investor can become more comfortable in the trade off between higher growth and higher volatility in the emerging market equity universe.