Emerging markets for diversification

While emerging markets are important for the diversification of a global equities portfolio, with an emerging market standard index fund investors do not fully exploit the diversification potential

While emerging markets are important for the diversification of a global equities portfolio, with an emerging market standard index fund investors do not fully exploit the diversification potential.

Standard indices weigh the individual equities according to size and ignore factors such as return, volatility and correlation. It is particularly with investments in emerging markets that it pays off to focus on risk parameters.

In this article, we examine the properties of alternative weighting methods for investments in emerging market equities.

Alternative weighting methods

An advantage of indexing lies in the disciplined implementation according to clearly defined rules.

For capital weighted indices (henceforth referred to as “standard indices”), the size (market capitalisation) determines the weighting of the individual equity title. This can result in individual equity titles having considerable weight in a portfolio simply because of their size.

Weighting determines the portfolio’s return and risk. Alternative weighting methods do not apply market capitalisation to determine their weight, but use other methods.

These new approaches are also known, for example, as “smart indexing” methods: “indexing”, because the investment process continues to be based on transparent rules and there is no discretionary room for portfolio management; and “smart”, because it is particularly the risk and return properties as opposed to the size that determine the weight of the individual equities in the portfolio.

With smart indexing, the portfolio weightings are determined by heuristic rules (equal weighting, fundamental indexing) or scientifically-based optimisation methods (minimum variance, maximum Sharpe ratio).

In their long-term perspective study for the American equity market, Chow, Hsu, Kalesnik and Little (2011) show that, compared with a standard index, all the above mentioned alternative weighting methods improve a portfolio’s return-risk profile. Minimum variance optimisation in particular considerably reduces the risk and, with time, generates an annual excess return after costs.

Less loss makes the difference

Minimum variance properties are particularly valuable in a negative market environment. With reduced volatility and less maximum loss in the case of market crashes, an investor loses less and his investments regain their initial value more rapidly.  This is according to the simple rule: A loss of 50% requires double the return to regain the initial level of the original investment.

Related to the emerging markets, the minimum variance portfolio delivers an annual excess return of 2% and reduces the risk (volatility) by more than 20%.

Compared with the 10 worst months, the minimum variance portfolio lost considerably less in nine out of the ten months than the standard index.

Unidentical twins

There are two important differences between emerging markets and developed markets: extreme values (great profits/loss) occur more frequently and are greater and emerging markets take longer to recover from market crashes. Both characteristics melt the performances.

Therefore, it is very important to consider the risks of emerging markets in a portfolio. Products such as index funds or ETF on standard indices are not sufficient. Minimum variance portfolios, on the other hand, allow for efficient diversification and, therefore have less capital loss and also shorter recovery periods than standard indices. These effects are finally manifested in a higher long-term average return.

With strong positive market development, the minimum variance portfolio can drop below the return of a standard index. An excess return is more valuable, particularly in emerging markets in negative market phases than in positive market development, because maximum losses are more frequent and more intensive compared to the developed markets.

It is therefore reasonable with portfolio optimisation to focus on the risk factors. Interestingly enough, volatility, value-at-risk and maximum loss of minimum variance portfolios for emerging markets can sooner be compared with the standard index values for developed markets than with the emerging markets standard index. A traditional investor, who up until now has only invested in developed markets, can expand his equity universe and diversify further without taking higher risks.

Conclusion

The comparison between minimum variance portfolios and the capital weighted standard index shows that an efficient portfolio structure cannot be attained by purchasing a simple index fund. Minimum variance optimised equity portfolios are considerably more stable in most market phases.

In the long-term this gives them a head start which can hardly be caught up on, even when in extremely positive market phases the standard indices usually exceed them. The properties of minimum variance portfolios are not only limited to emerging markets. They are applicable to all liquid equity markets.

This article was originally published in the Swiss financial newspaper “Finanz und Wirtschaft” on March 26 2014 in German by Pius Zgraggen, chief executive officer and founding partner, Michael Frei, partner of OLZ, and Cyril Bachelard, senior research analyst, OLZ & Partners Asset and Liability Management AG.