The Hindu Business Line : Time for investors to look at emerging markets

Money managers in India should consider diversifying into other emerging markets, as they can expect considerable uplift in portfolio returns from such exposure.

HSBC Mutual Fund has filed a draft offer document with SEBI to launch a new product - HSBC Emerging Markets Fund. The fund will take equity exposure in emerging markets such as Brazil, Mexico, Russia and China.

The concept of portfolio diversification has so far been argued from the point of view of investors in the developed markets. The argument has not been so compelling for investors in the emerging markets. The reason is not far to seek.

Emerging markets have consistently outperformed the developed markets. The Dow Jones BRIC 50 Index (Brazil, Russia, India and China), for instance, generated 3-year annualised returns of approximately 45 per cent compared with a measly 10 per cent on the Dow Jones Industrial Average (DJIA) over the same period. Why then would investors in emerging markets diversify into developed markets when their home-market generates superior risk-adjusted returns?

That said, the case is now compelling for India to look at other emerging markets. Asset prices in India are no longer cheap. The S&P CNX Nifty, for instance, rose nearly 50 per cent last year. The index will continue to march ahead albeit at a slower speed. The momentum in other emerging markets such as Vietnam, China and Chile are likely to be higher. Indian investors could, therefore, enhance their risk-adjusted returns by adding emerging market stocks to their portfolio.

A portfolio manager diversifies to enhance the risk-adjusted returns. Assume a portfolio of just two stocks. If one stock were to move down, an optimal portfolio construction would mean that the other stock would move up. In a Markowitz mean-variance space, a portfolio manager adds stock to a portfolio if that stock reduces overall risk for the same level of return or increases overall return for the same level of risk.

Active portfolio managers use this process to engage in tactical asset allocation. This refers to an asset allocation process where money managers actively switch across stocks and bonds or among sectors within the equity markets or across equity markets to enhance portfolio returns. Such money managers take a view on the stock, sector and overall market movement and build their asset exposure accordingly.

Portfolio mangers who engage in such tactical asset allocation can enhance returns through exposure to high-volatility high-returns markets. It is in this context that portfolio managers in India should view exposure to emerging markets.

Emerging markets

Active managers (those who engage in active security selection) should consistently generate alpha returns to justify high management fees. Alpha returns refer to the excess returns over the fund's benchmark returns. Suppose a fund is benchmarked to the MSCI Emerging Markets Index,ifthe fund returns 20 per cent while the Index returns 15 per cent, the portfolio manager is said to have generated alpha returns of 5 percentage points.

Consistently generating alpha returns is, however, not easy. If a portfolio manager generates alpha returns, it will not be long before other mangers and naïve investors catch the trend. Alpha returns then vanish and become beta returns. That is, when a certain investment strategy is exploited, it becomes part of market (beta) returns.

Fortunately, investing in emerging markets is not fraught with such risks, at least for now. The reason is that asset prices in such markets are still consistently mis-priced, providing opportunity to generate alpha returns. The Karachi Stock Exchange is one such market. This market saw a high of 12,273 and a low of 8,766 during 2006.

Of course, generating alpha returns requires access to corporate information to engage in active security selection. This could sometimes pose a problem, especially in markets where corporate and market regulatory requirements are not so stringent. One way to overcome this problem is to engage in market timing as a form of tactical asset allocation. Market timing is primarily the domain of chartists and quantitative money managers.

It is important not to overly constrain the portfolio with market-specific and sector-specific weights. A constrained portfolio, for instance, may specify that the fund should not have more than 15 per cent exposure to any one emerging market. But what if the money manager strongly believes that Brazil is likely to outperform India in the next two years? The money manager should be allowed to take a tactical call on the market. The portfolio should be actively monitored for downside risk.

Passive Returns

Passive portfolio management is no longer a passé in the developed markets since generating alpha returns is difficult. Moreover, passive management helps lower management fees and transaction cost because of infrequent portfolio rebalancing.

Strictly speaking, passive management should not find a place in an article on emerging markets, as the market microstructure allows for alpha returns. But what if the management fees for generating such returns is high? In such circumstances, it still makes economic sense for money managers in India to take exposure in the investable indices in various emerging markets. So long as the emerging market indices' risk-adjusted return is higher than that of the home-index such as the BSE Sensex, the money manager would have successfully done her job.

Associated risks

With alpha returns come associated costs. Such costs can be very high in the emerging markets. For one, Indian investors would be exposed to currency risks. For another, even robust low co-movements among emerging markets can break down due to catastrophic global event.

Portfolio managers can control both these risks. The currency risk can be controlled with a currency overlay manager. Such a manager will take exposure to currency forwards to neutralise the currency risks. This measure will take a few basis points off the total returns. The breakdown of robust low co-movement among markets is a tail risk. That is, these are low-probability high-disaster events. Managing tail risk can be very expensive. As long as the fund is currency-hedged, such risk should not act as a deterrent in taking exposure to other emerging markets.

The argument is this: If a money manager were fully invested in domestic stocks, the portfolio will be anyway exposed to downside risk from a catastrophic global event. Exposure to the emerging markets would be no different as long as the currency risk is neutralised, because the magnitude of the downside due to a catastrophic global event may not be vastly different among the emerging markets.

Nevertheless, it may be prudent for investors to ensure that they do not carry an exposure of more 25 per cent of their total portfolio to such markets. Overexposure to other emerging markets could drag down returns due to high transaction costs and management fees.

Scope for returns

It makes economic sense for portfolio managers in India to diversify into other emerging markets. The reason is that the money managers can expect significant uplift in portfolio returns from such exposure. Tactical asset allocation may be best form of active management while indexing may still provide enhanced returns for lower fees. It is highly likely that HSBC Emerging Markets Fund may soon witness a barrage of peer funds, as the concept catches investor interest.

(The author, a CFA charter-holder and a Certified Financial Risk Manager, is a consultant-analyst with an independent equity research firm based in Toronto, Canada)

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