KHYB - How To Invest In Emerging Markets In Volatile Times
Summary
- The effects of volatility in 2022 have been felt by investors globally — however, there may be opportunities to be selective within emerging markets.
- Accessing less-volatile stocks in emerging markets through minimum volatility ETFs may be attractive as a way to maintain exposure to emerging market stocks but with potentially less risk than U.S. equities*.
- Despite recent underperformance by emerging market equities, a long-term view can make a case for maintaining a strategic allocation.
By Gargi Pal Chaudhuri, Robert Hum
2022 has proven to be a volatile year, and not just for U.S. investors. Global assets, including emerging markets, have been hit by a combination of a stronger dollar, increased geopolitical tensions and weakness in global demand.
Despite the ongoing challenges, we believe investors may want to consider sticking with emerging markets ((EM)), albeit selectively and by leveraging minimum volatility strategies . Here's a primer on emerging markets and our rationale for why investors shouldn't abandon these developing countries.
WHAT ARE EMERGING MARKETS?
While there's no official definition, the International Monetary Fund designates certain countries as "emerging" based on economic factors such as per capital income, integration into the global financial system, and the nature of a country's exports. 2
The IMF considers EM economies such as China and Brazil as being less mature than those of so-called developed nations, such as the U.S. and Germany. On the flip side, emerging economies are viewed as being more advanced than "frontier" economies such as Sri Lanka.
The IMF uses these designations to determine whether a particular nation is eligible for loans and other types of assistance. Investors use them to find opportunities for growth and to add diversification to their portfolios, which brings us to why we believe investors may want to consider emerging markets today.
EMERGING MARKETS: STAY THE COURSE AFTER A ROCKY RIDE?
To be sure, emerging markets have been challenged recently. Over the trailing 5-years, EM stocks have returned a measly 1.1% and badly underperformed U.S. stocks from 2012-2022. 3 With higher levels of volatility 4 and low realized returns in recent years, many investors may be wondering: Why bother with emerging markets?
While the recent past may give us pause, taking a long-term view can paint a drastically different picture, as the chart below highlights.
U.S. vs. EM: A tale of two decades (Source: BlackRock, Morningstar as of 12/31/21.)
| This chart shows the annualized returns (%) of the S&P 500 Index and the MSCI Emerging Market Index for the indicated time periods. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com . Chart description: Bar chart showing the trailing returns of the S&P 500 Index and MSCI EM Index over two separate 10-year periods. |
It's impossible to say how the next decade will turn out, of course. But maintaining an allocation to emerging market equities may make sense from a diversification standpoint, as performance can vary greatly between US and emerging markets over long time periods.
While slowing global growth may hamper emerging markets, there are several reasons to be optimistic of EM longer term. From a valuation perspective, emerging markets look attractive relative to developed markets. Over the last 10 years, developed equities have traded at a 35% premium relative to their emerging market counterparts. As of March 2022, the spread has grown as developed equities are now trading at a 57% premium. 5
On a fundamental basis, EM economies appear to be in better shape now compared to past Federal Reserve hiking cycles. When the Fed raises interest rates, it often results in a stronger dollar. This is usually perceived as a headwind for emerging markets, making it harder for them to attract foreign investment and pay their debts, which are often denominated in dollars. However, that risk may be mitigated by this cycle: The dollar is at a multi-decade high vs. other major currencies and we believe it is not likely to move significantly higher. 6 Any decline in the dollar could therefore potentially benefit EMs.
Moreover, many emerging market central banks started to hike interest rates in 2021 - ahead of the U.S. Federal Reserve. As a result, EM central bankers may have room to ease monetary policies earlier than in past cycles.
Additionally, many emerging market exporters have benefited from the structural shortage in commodities and could continue to gain from elevated commodity prices. Lastly, the trend of friendshoring - companies relocating their supply chains to closer, less antagonistic countries - could be a tailwind for EM exposures in Southeast Asia and Latin America.
Speaking of Latin America, its 2022 year-to-date performance is a good reminder of the potential benefits of a strategic allocation to emerging markets generally, and the importance of being selective within the sector. As of the end of August, U.S. equities and European equities have both declined more than 16% year-to-date, while Latin America managed to stay in positive return territory. 7
Regional differences: equity market performance YTD (Source: Morningstar as of 8/31/22.)
| This chart shows the performance of equities in the US, Europe, and Latin America. US equities represented by the S&P 500 Index. European equities represented by the MSCI Europe Index NR. LatAm Equities represented by the MSCI Emerging Markets LatAm 10/40 Index. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com . Chart description: Line chart showing the performance of US, European, and Latin American equities YTD. |
ACCESSING EMERGING MARKETS IN A RISK AWARE WAY
While Latin America has been a standout, investors may want to be mindful of the amount of risk they are bearing in their portfolio from EM equity allocations. Historically, emerging market stocks have been approximately 17% more volatile than their U.S. counterparts. 8
Investing in lower risk emerging market stocks through a minimum volatility ETF like the iShares MSCI Emerging Markets Min Vol Factor ETF ( EEMV ) - may be worth considering. Since 2011, the MSCI Emerging Markets Minimum Volatility Index, the index that EEMV seeks to track, has demonstrated less risk than even equities in the U.S. and international developed markets.
EM Min Vol has historically been less volatile than broad developed markets (Source: BlackRock, Morningstar as of 11/1/11 through 7/31/22. )
| This chart shows the annualized risk (%) of the S&P 500 Index, MSCI EAFE Index, MSCI EM Min Vol Index, and the MSCI EM Index. Annualized risk is represented by standard deviation, which measures how dispersed returns are around an average. A higher standard deviation indicates that returns are spread out over a larger range of values and thus, more volatile. Chart description: Bar chart showing the annualized volatility of US, international developed, and emerging market equities in comparison to the MSCI EM Min Vol Index. |
Investors that are able to maintain their strategic asset allocation to EM equities may be rewarded over time. While we are not yet ready to be fully bullish on emerging markets, there may be select opportunities within EM via minimum volatility strategies in today's environment. Allocating to less volatile emerging market stocks through EEMV can help investors gain exposure to EM companies but with risk levels that are even lower than the volatility found in the U.S.
Footnotes*1 Source: See "EM Min Vol has historically been less volatile than broad developed markets" chart. 2 Source: International Monetary Fund. 3 Source: Morningstar Direct as of 7/31/22. Emerging market stocks represented by the MSCI Emerging Market Index. U.S. stocks represented by the S&P 500 Index. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. 4 Source: Morningstar Direct from 11/1/2011 - 7/31/2022. The S&P 500 Index, MSCI EAFE Index, and MSCI Emerging Markets Index have annualized risk of 13.8%, 14.4%, and 16.3% respectively. Annualized risk is represented by standard deviation, which measures how dispersed returns are around an average. A higher standard deviation indicates that returns are spread out over a larger range of values and thus, more volatile. 5 Source: Reuters DataStream as of March 2022. Premiums being calculated based on P/E ratio. DM and EM represented by the MSCI Developed Markets Index and MSCI Emerging Markets Index respectively. 'Price/Equity' ratio is the price of the stock divided by the company's earnings per share, aggregated to the index level. 6 Source: Bloomberg as of September 8, 2022. 7 Source: Morningstar as of 8/31/22. Performance based on S&P 500 index, MSCI Europe Index and MSCI EM Latin America 10/40 Index. 8 Source: BlackRock as of 8/31/22. Portfolio risk is being measured between 11/1/11-7/31/22. EM Equity represented by the MSCI Emerging Markets Index. US equities represented by the S&P 500 Index. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. MSCI EM Index had annualized risk over the period of 16.2% compared to the S&P 500 Index with an annualized risk of 13.8%. Annualized risk is represented by standard deviation, which measures how dispersed returns are around the average. A higher standard deviation indicates that returns are spread out over a larger range of values and thus, more volatile. |
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This post originally appeared on the iShares Market Insights.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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How To Invest In Emerging Markets In Volatile Times