In the News

How Retail Investors Can Make the Most of Emerging Markets

3 October 2019

Investors are drawn to emerging markets because of how far they’ve come and what they promise. These are geographies at the cusp of becoming developed markets and they’re further along the development path than frontier markets. That’s a generally accepted understanding of emerging markets (EMs) in the absence of a universal definition.

Some countries, such as Vietnam or Pakistan, tread a blurred line between frontier and emerging markets. But the unifying feature of EMs is this: once they begin rising, they do it swiftly.

In fact, investors want EM exposure before or as that rise commences. Real gross domestic product growth provides some insight into future expansion, especially vis-à-vis low GDP per capita – low-income countries (below $10,000 per capita per year) often have annual GDP growth above 5%.

But when it comes to investing, GDP growth alone in EMs can be misleading. Unconventional accounting methods or fiscal stimulus, like in China and India, can raise GDP value on paper, but not in practice.

Recent research suggests that GDP growth in EMs does not always translate into higher returns for underlying businesses. So, while GDP growth may be a sign of a healthy economy, savvy investors should be wary.

Smart beta funds and ETFs in recent years have enabled investors to gain some disciplined exposure to EMs. In our own experience, the Henderson Rowe FTSE RAFI Emerging Markets Fund has performed well since commodity and energy markets recovered in 2016.

After oil prices collapsed in 2015, most commodity-based markets suffered, sinking to 10-year lows. The Brazilian Bovespa declined 35% in 2015 and sold at 9x forward price-to-earnings ratio.

Due to its value tilt, the Henderson Rowe FTSE RAFI Emerging Markets Fund – carrying substantial positions in Brazil, Russia and South Africa at the time – returned over 90% since December 2015 compared to the 60% for MSCI Emerging Markets ETF.

Fear of Missing Out

But despite this recent success, the practical reality is that investing in a single “factor” – for example, choosing value stocks trading at reasonable prices – can result in long periods of underperformance; most retail investors will not have the patience to stick with the strategy, thus missing out on long-term returns.

Jason Hsu, a smart beta pioneer and a director of Henderson Rowe, has written extensively about this phenomenon. The performance drag resulting from retail investors unsuccessfully attempting to time the market can be as large as 2% per annum.

One way to address this challenge for retail investors is to adopt a “multi-factor” approach. Rather than employ a single-factor approach, investors adopt a strategy that combines multiple factors – for example, value, growth and quality – for a broader portfolio.

A key reason underlying the popularity of multi-factor strategies is that they have historically offered smoother, more consistent returns over the long term, unlike single-factor strategies, which more often experience the protracted headwinds described above.

An easy way to understand multi-factor investing is to think of each factor as a nutrient. Factors such as value, quality and momentum provide certain benefits to a portfolio, much in the way that vitamins A, B and D each provide distinct benefits to the body. When nutrients are combined in a meal, as factors are in a portfolio, they create balance.

Meanwhile, a single-factor strategy is like carb-loading before a big workout, providing a strong boost – but only in a specific context. Unlike single-factor strategies, multi-factor strategies expose a portfolio to diverse and balanced drivers of returns, which creates a smoother investment trajectory in favour of long-term performance.

A Localised Approached for EM Investing Challenges

Of course, applying factors in emerging markets presents its own challenges. Unlike developed markets, which tend to be homogeneous, emerging markets offer up distinct regional quirks driven by politics, regulations, accounting standards, or other unique idiosyncrasies. That means that factors will behave differently across markets.

For example, Chinese companies often take a different approach to corporate governance and financial reporting compared to most businesses in the West, and these differences are also treated differently by local market participants. A localised approach embedded into factor research can effectively address these challenges. Local fundamental insights can identify signals that deepen market understanding and enhance quant strategies in EMs.

Multi-factor strategies are arguably the most suitable and comfortable way for retail investors to gain exposure to emerging markets. Such strategies are becoming increasingly available, with a number of ETFs now offering investors easy access to professionally constructed multi-factor portfolios.

By introducing multi-factor products into their asset allocation process, investors can not only harness the excess return from each factor bucket, but also increase a portfolio’s diversification.

Each factor has historically performed differently at different stages of the business cycle. This means combining different factors – particularly the localised factors just described – can result in lower correlations, leading to a more robust asset allocation framework.