Constructing a Lower Volatility Emerging Market Portfolio

One of the key themes dominating the exchange-traded fund (ETF) industry flows over the last 12 months has been the meteoric rise in assets of minimum-volatility (min-vol) portfolios. Year-to-date, these strategies have pulled in over $12.6 billion of new money.¹ Of the 34 strategies with “volatility” included in their respective fund name, 32 have attracted new money. While flows have largely been concentrated in U.S. and EAFE index benchmarked strategies, emerging markets have seen nearly $1 billion of flows. From some investors’ point of view, one size seems to fit all markets. While many debate if there is a “bubble” brewing in these approaches, another school of thought is that it’s simply performance chasing. Being positioned in defensive vs. cyclical sectors has been a great trade across markets year-to-date! However, for emerging markets, the single largest driver of volatility over the last several years has been the dramatic decline of foreign currencies against the U.S. dollar. In my view, relying on a strategy that seeks to minimize the volatility of an asset class while not focusing on the root cause of that volatility is pointless. In the remainder of this piece, we’ll argue that emerging market corporate bonds offer a compelling option for investors concerned about volatility in emerging markets.   How Low Is “Min” One of the common critiques of min-vol is that it doesn’t actually mean low vol. Below, we compare the rolling 12-month standard deviations of emerging market equities (market capitalization-weighting² and min-vol³) and emerging market fixed income (locally denominated⁴ and U.S. dollar-denominated corporates⁵). As you can see, the primary driver of volatility was not necessarily the geographic region but, rather, whether the approach contained currency risk or not. For EM min-vol, the strategy has been effective in reducing volatility relative to market capitalization-weighted EM equities. However, with standard deviations comparable to U.S. equity markets, “minimum” does not necessarily mean low in absolute terms. In fact, the EM min-vol standard deviation is more akin to EM local debt due to its exposure to currency risk. Again, positioning to more defensive, “bond-like” sectors of the equity market is what these approaches aim to do. In our view, a clear enhancement to an investment strategy would be to switch from stocks to bonds when concerns about volatility in EM rise.   Emerging Markets Rolling 12-Month Standard Deviation 12/31/11-6/30/16   Performance, Correlation and Return Drivers While investors appear to be buying these strategies for their purported volatility characteristics, what we think they should be focusing on is what those approaches have delivered in total returns. Over virtually every period we examined, min-vol equities were able to reduce volatility by approximately 4% per year compared to EM equities. However, switching to EM fixed income (local debt) netted an additional reduction of 2% compared to EM min-vol. Finally, by avoiding currency risk altogether, investors were able to not only reduce volatility but significantly boost returns as well. In fact, over the entire period, EM corporates outperformed min-vol equities by 3.9% per year with only 32% of the volatility. While correlation against EM equities was lower than other strategies with currency risk, EM corporate bonds averaged a respectable 0.83 over the available data history.   Emerging Markets Annualized Performance 12/31/10-6/30/16 Ultimately, the drivers of return for EM corporates and EM min-vol equity strategies are different. EM corporate bonds expose investors to U.S. interest rate risk, whereas EM equity performance will be impacted by currency fluctuations. Both will be impacted by the outlook for the financial performance of EM corporations. While EM markets have rebounded sharply so far in 2016, uncertainties about the strength of the global economy remain. In our view, by allocating to EM corporate debt, investors can maintain exposure to emerging markets, significantly reduce volatility and also boost income potential to power returns over market cycles. While the results are of course far from guaranteed, investors looking for a true low-vol approach to emerging markets should consider allocations to EM fixed income.         ¹Source: Bloomberg, as of 6/29/16. ²As proxied by the MSCI Emerging Markets Index. ³As proxied by the MSCI Emerging Markets Minimum Volatility Index. ⁴As proxied by the J.P. Morgan GBI-EM Global Diversified Index. ⁵As proxied by the J.P. Morgan CEMBI Broad Index.