Author: Jay Kumar
- Global emerging markets have provided very strong returns for long term investors.
- However, investors have to be prepared to accept higher volatility over shorter periods of 3 years and less.
- Significant performance dispersions across regions, countries, sectors and styles factors provide substantial opportunities for active managers.
- Smart-beta or factor strategies have delivered mixed results – while Minimum Volatility and Sustainability factor indices have delivered strong results, traditional factor indices such as Value and Growth have disappointed.
- The level volatility and dispersion of risk factor across major countries continue to rise, reflecting greater geopolitical risks and country level policy risks.
- Despite the rising volatility (since 2017) of EM asset class, the correlations between BRICS constituents continue to diverge.
Emerging Market equities can be a source of strong returns over the long term.
Over the long term, emerging markets (EM) can be an attractive source of uncorrelated returns for investors. The total return chart (Exhibit 1) since 2005 shows EM equity has outperformed DM, World and Frontier markets by a notable margin. Investments in EM (unhedged) grew at an annual compound rate of 8.44% in comparison to a Developed Market (DM) average of 7.31% p.a since 2005. However, it should be noted that most of this growth differential comes from the previous decade and the volatility of returns has been much higher in the most recent decade, particularly relative to the DM markets. In order to realise the long-term benefits of the asset class, investors need to take a long-term perspective and be prepared to withstand material drawdown over the shorter periods of less than 3 years.
Recent performance shows notable dispersion in constituent performance.
The current cyclical upswing in EM commenced in January 2019 when the US Federal Reserve Bank indicated it's intentions to pause interest rate tightening in the US. The fundamental backdrop for most EM countries was relatively strong, however, in 2018 investors was increasingly concerned about the impact of the USD rate tightening on capital flows and its impact on EM currencies. The change in the US rate policy significantly boosted investor sentiment towards emerging markets and led to significant institutional flows into EM equities so far in 2019 and strong reversal in performance of EM equities.
Exhibit 2 shows the 1 year returns (that end in March 2019) by regions and countries. There are three major regions in EM – Asia, Europe and Latin America and 23 nations that are part of the Emerging Market index (MSCI).
Our analysis shows the returns for regions and countries are highly diverse. Over the past year, Latin America and Asia marginally outperformed the broad index while Europe, Mid-East and Africa underperformed. Further, despite being hit by a political and economic embargo back in 2017, Qatar managed to have the highest return over the past 12 months (31.83%). Qatar was followed by India and Colombia, 15.27% and 13.72%, respectively. Turkey, Pakistan, Greece and South Africa were the worst performing countries with returns of -35.50%, -31.56%, -17.51% and -11.46%, respectively. All these countries experienced large political or debt related headwinds and significant de-ratings of their equity market.
Cyclical Performance of two major countries in EM – India and China
Emerging markets include two of the world's most populous countries – India and China. These two countries represent almost 40% of MSCI EM index weights for instance. China's weight in the index has gone from 17% in 2014 to 30% today, which is quite substantial. It is expected to rise further in the coming months according to MSCI.
Exhibit 3 provides some context on the performance of these two countries on a 12-month rolling basis. While the two returns series are highly correlated, there are periods when they diverge in performance. For instance, in more recent times (since July 2018), Indian equity markets have outperformed China by more than 10% (annualised rolling). The China-US trade war, which started in April 2018, was detrimental to the Chinese stock market as returns were the worst in a decade. Over the longer period of 10-15 years, Chinese stocks have exhibited greater volatility of 12-month rolling returns than Indian equities. The more recent outperformance of Indian equities is also interesting given it has coincided with the Indian Federal elections that is currently underway. The outcomes of the election will not be known until May 23 2019 but it is widely expected that the current BJP government led by PM Narendra Modi will return to power.
Sector dispersion has been very high over the past year; IT and Staples lead over the longer term.
Our analysis of sectoral compositions shows interesting patterns of high dispersion but also high level of persistence by IT sector over the longer term.
Exhibit 4 shows returns from GIC sectors and over various time periods. Over the past 12-month sector, performance diverged quite significantly with Energy being the highest earning sector of 18.14% and Health Care being the worst performing (-17.30%).
Over a longer term period of 15 years, Consumer Staples has outperformed all other sectors delivering an annual return of 11.93% but returns have been slowing for the sector in recent times with only 5.28% over the past 3 years and negative returns (-1.05%) over the past year.
IT sector has delivered very consistent results over the past 5, 7 and 10 year periods with returns in higher teens over these periods. That said, the last 12 months have been very volatile with the sector delivering -3.7% returns.
The Importance of Style and Risk Factors in EM
Apart from country, regional and sectoral risks, style factors can also explain part of the dispersion in returns for EM equity market constituents.
Exhibit 5 shows the style factors that have had notable impact on EM stock returns over the past 1, 3 and 10 years. Overall, the data-set shows Growth, Value and Quality factors have had most influence on EM equity returns. Over the past 1 and 3 years, Quality factors had marginally higher impact than Growth, Value or Macro factors.
Within these broad style classifications, the data shows the impact of more granular factors. For instance, over the past 10 years, Forecast 1 year revisions and Return on equity factors were associated with very strong and positive return premiums. On the other hand, Low accruals, currency (non-USD exposure), and market cap (size) were associated with negative return premiums.
The elevated level of dispersion and volatility noted across regions, countries, sectors and styles is underpinned by rising uncertainty around economic, geopolitical and country specific issues. We believe this provides an attractive opportunity for active investors to buy superior companies, countries, themes during these periods to add significant alpha in coming months and years.
Performance of Smart-beta Indices
There are various indices that are available to investors to replicate or invest in linked ETFs to capture factor-specific returns. Exhibit 6 shows the performance summary of most popular smart beta indices in EM.
The dataset shows that the MSCI EM Minimum Volatility index (minimum volatility factor) delivered the best returns over the past 12 months and indeed over the long-term (15 years). However, sustainability indices (ESG and SRI focused) which were only introduced in the last 5-10 years have delivered very strong returns over the past several years. For instance, the MSCI EM ESG Leaders ranked 1st over a 5-, 7- and 10-year periods. These performance patterns are very interesting as they show traditional smart-beta factor indices may are losing their performance edge and no longer enjoy the following as they did several years ago.
In addition, the MSCI EM Value index ranked 2nd over the past year but was the worst performing smart-beta factor over 5-, 7-, 10- and 15-year periods.
On the other hand, Growth index was the best performing index over the 3-year period but was the worst performing over the past 12 months and second worst performing over a 15-year period.
Geopolitical risks and Policy uncertainty have underpinned rising volatility in EM
Investors have been very wary of the geopolitical and policy risks that influence EM stock markets. The uncertainty can be gleaned from the rising dispersion at every level of the market – region, country, sector and styles.
Our analysis of the absolute level of volatility also points to the rising uncertainty.
Exhibit 7 presents the stock market volatility data on the broad MSCI EM Index as well as the major constituents - BRICS
nations (Brazil, China, India, Russia and South Africa). The data shows volatility for Global EM has subsided considerably since GFC (currently half of what it was in 2009) to 10.63% annualised (AUD)which is in the 3rd quartile of its historical volatility average. More importantly, the data shows the EM asset class volatility on a rolling 12-month basis bottomed in early 2017 and has been steadily rising since then.
Further, the dataset demonstrates that over the period of March 2004 to March 2019, all five BRICS countries have exhibited higher rolling volatility than the overall Emerging Markets. Although volatility levels have converged since the GFC of 2008, volatility in Brazilian and Russian equity markets have been significant and divergent since 2015. Brazil's volatility is currently the highest out of the group and has reached its GFC levels at 36.27%. It is currently in the upper first quartile of its history. In addition, the volatility of Indian equity market has been steadily rising since 2017. The rising volatility levels in itself are not the reason for avoiding investment in EM. Investors should be cognizant of the underlying shifts in risk patterns and where possible allocate their money via active managers that have skill in navigating through uncertain times.
Despite the rising macro-uncertainty in EM, correlation between BRICS countries has subsided
Generally, a rising volatility coincides with rising correlation. When this pattern of behaviour is observed across markets or asset classes, investors need to be wary of diversification breakdowns within portfolios. However, the current behaviour in EM and in particular BRICS markets is unusual.
The 36-month rolling correlation of BRIC countries to the overall MSCI EM Index is shown in Exhibit 8. Correlation of Chinese equity market to the EM market has been steady at 76% with a very tight historical range. This is not a surprise because China makes up more than 20% of the EM equity market.
Correlation of Brazilian and Russian equity markets has subsided significantly since 2015. Overall, country level correlation dispersion outside the BRICS still exists which means investors with well diversified exposures across broader emerging markets can benefit from country level diversification.
A notable trend is that Indian equity market's correlation has been steadily rising since 2015. This most likely reflects its growing importance within the region, as well as increased flows in the Indian equity market since Prime Minister Narendra Modi took office in 2014. Over the past 6 months however, correlation has been rolling over and it remains to be seen if this will be extended post elections that are currently underway.
Despite the rising dispersion and volatility in Emerging market equities, long term investors can harvest superior returns from this asset class. Notable dispersions across regions, countries, sectors and styles mean active managers are better placed to take advantage of stock, country and sector level anomalies and position the portfolio for strong outperformance in the coming years. Smart beta strategies based on MSCI factor indices have had mixed success in the asset class. While Minimum volatility and Sustainability factor strategies have done well, traditional Value and Growth indices have struggled. Rising geopolitical and individual country policy and political risks mean volatility for the asset class will continue to rise. We believe active managers are best placed to navigate through uncertain times and take advantage of opportunities for investors. Disclaimer The material contained in this document is for general information purposes only. It is not intended as an offer or a solicitation for the purchase and/or sale of any security, derivative, index, or financial instrument, nor is it an advice or a recommendation to enter into any transaction. No allowance has been made for transaction costs or management fees, which would reduce investment performance. Actual results may differ from reported performance. Past performance is no guarantee for future performance. This material is based on information that is considered to be reliable, but Foresight Analytics makes this information available on an "as is" basis without a duty to update, make warranties, express or implied, regarding the accuracy of the information contained herein. The information contained in this material should not be acted upon without obtaining advice from a licensed investment professional. Errors may exist in data acquired from third party vendors, and in coding related to statistical analyses. Foresight Analytics disclaims any and all expresses or implied warranties, including, but not limited to, any warranties of merchantability, suitability or fitness for a particular purpose or use. This communication reflects our quantitative insights as of the date of this communication and will not necessarily be updated as views or information change. All opinions expressed herein are subject to change without notice.