Eight ways to manage the volatility of your EM exposure

And there are plenty of ways to access it with different flavours and volatility levels. Volatility in itself is not bad if the investor has a sufficiently long investment horizon not to be a forced seller at the bottom of the market cycle.

Here are eight considerations to getting that balance right when looking at EM equities:

Diversification within emerging markets

Idiosyncratic risk – the risk of specific companies or countries – can be removed through diversification, leaving the portfolio with market risk. Global EM equity is a large, diverse asset class with ample opportunities to construct a well-diversified equity portfolio. 

Multi-asset emerging market investing

In addition, investors can build an emerging market multi-asset portfolio including a range of different asset and sub-asset classes: emerging market debt, infrastructure investments in emerging economies, emerging currencies and also EM hedge funds and private equity funds.

By blending different EM asset classes investors can construct a portfolio with considerably lower volatility than a pure equity portfolio.

However, investors should mind the liquidity risk of some of these assets, such as infrastructure, as well as the need for thorough due diligence – in particular when investing in private, unlisted assets.

Diversification across multi-assets

In a broader portfolio context, the important metric is not the volatility of an investment on a standalone basis, but how each investment contributes to the volatility of the entire portfolio.

Adding exposure to emerging markets in a multi-asset portfolio can actually reduce volatility due to diversification. 

Selectivity within emerging markets 

Emerging markets is a heterogeneous group of economies. Investors can focus on entire regions, individual countries or sectors to build a portfolio with a lower volatility than one that includes the entire emerging universe.

Or investors can exclude the more volatile markets to reduce the volatility of their EM exposure.

By blending emerging markets with the desired weighted risk factor exposure, investors can fine-tune the characteristics of their portfolio.

Active management

EM equities is a less researched market compared with developed equity markets, thus there are more opportunities for appropriately resourced active managers to generate excess returns.

Small schemes can probably only use collective investment schemes offering limited customisation, but allowing access to diversified, actively managed portfolios.

Freeing your manager is an important consideration for pension schemes. Blending a number of active managers can further mitigate volatility, as well as manager risk.

Hedging

Investors can reduce the volatility of EM equities by hedging the market beta exposure.

For example, investing with an active fund and shorting the EM equity index can give nearly a pure exposure to the manager’s excess return without the exposure to EM equities.

The volatility of excess returns can be lower than that of the market, depending on the tracking error of the manager – absolute volatility is transformed into relative volatility.

Downside mitigation

Cutting the tail of the return distribution is another way to mitigate the volatility of EM investing.

This can be done by buying insurance in the form of put options, or by adding protection in the form of gilts that should perform well in case of a flight to quality, during which emerging markets are likely to fall and gilts to rally.

To purchase put options, however, investors need to pay a premium – and buying gilts may cost in terms of lower overall portfolio performance since gilts are generally not expected to generate a return as high as that of emerging markets over the long term.

Indirect exposure

Investors who want to get exposure to emerging markets but have no appetite for high volatility can indirectly invest through stocks of UK companies that do business in emerging markets – EM equities may not even appear in the asset allocation.

However, these companies’ fortunes are linked to the UK economy and some diversification benefits of investing in EM equities for a UK-biased portfolio would be lost. 

Yoram Lustig is head of UK multi-asset investments at Axa Investment Managers