In the current market report, I am continuing my analysis of emerging markets (EM) investment opportunities.

Emerging Markets Debt (EMD): An Opportunity in an Unstable Environment

EMD offers attractive returns. EMD offers exceptionally attractive yields in low-yielding environments. I see the most attractive opportunities in high yield debt from emerging markets, especially government bonds. High emerging market yields are currently trading at historically wide spreads compared to US high yield:

High government yields are not currently the only attractive option in EMD. Investment grade corporate spreads in emerging markets also remain larger than the US investment grade corporate spreads (chart right), despite their strong and improving trend in credit bases.

Of course, emerging countries are not homogeneous, and selectivity is important. Turkey, for example, is facing a balance of payments crisis and Sri Lanka is struggling with debt sustainability. Therefore, we believe that bottom-up analysis and active investment remain essential for EMD Investors.

Emerging markets debt rebounded sharply from March lows as Investors’ fears of a pandemic slipped. However, even as volatility may increase in the near term – mainly as a result of uncertainty about the US election – still see significant opportunities. The following are important signposts:

1. A weaker US dollar can deliver growth. The US dollar is overvalued. We believe that the dollar may weaken due to the current account deficit, the (growing) budget deficit and low interest rates.

   Generally, when the dollar is weak, capital flows into emerging market assets in search of higher growth and profitability. A weaker dollar would also benefit emerging nations by lowering the cost of servicing the existing debt denominated in US dollars. In the longer term, it may also increase the attractiveness of local currency debt.

2. US elections matter. From rising tensions between the US and China to infrastructure and energy policies, the outcome of these US elections may have more impact on risky assets. EMD is no exception.

   Emerging countries would benefit from conventional diplomacy and more predictable trade negotiations with China, which are more likely under Biden. A lower background risk would create a more favorable environment for EMD assets. Fiscal stimulus and increased infrastructure spending in the US would also stimulate emerging countries and companies that provide the raw materials they need.

   The new administration may also have different views on the role of the International Monetary Fund in the global economy. This may result in additional or reallocated special drawing rights, which may increase the sources of funding for emerging countries.

3. Emerging Markets (EM) are resilient. Experience with COVID-19 in emerging countries was similar to that in developed markets – some countries did well, others not. Even emerging nations like Brazil and India have stabilized COVID-19 cases and bent the curve so far.

   Overall, emerging governments have reduced downtime to conserve revenues and limited fiscal stimulus to prevent credit deterioration. As a result, concerns about systemic insolvencies caused by the pandemic have not materialized. The recent bankruptcies of Argentina, Ecuador and Lebanon were predicted long before 2020.
   We expect this kind of broad resistance to persist. And as more information is known about potential vaccines, improved treatments, and even better testing options, global growth should be accelerated – positive for EM assets.

In today’s market challenges, it is worth looking at the market from different angles

How did your active stock portfolio deal with the risks during the downturn? Has the portfolio maintained a strategic focus while adapting to a developing crisis? What is the best way to determine the long-term impact of a pandemic on the global economy?

The answers to these questions require a broad understanding of what active stock portfolio managers are being paid for. Breaking the baseline is essential – but that is only one dimension of the action selection role. In our opinion, the COVID-19 crisis has strengthened many of the functions that active managers perform for investors. While passive investing is attractive as a cheap way to gain access to the market beta, we believe that active strategies offer significant benefits, especially in today’s volatile and uncertain environment.

Here are proactive ways to evaluate how active managers can help Investors survive today’s volatile market conditions and achieve long-term investment success.

Risk management is more than just a black box

Risk management has become much more complicated in recent years. Investors have more technology tools to help ensure a portfolio stays on track in the face of volatile market periods. Since the global financial crisis, most of the risk models used by portfolio managers have become much more sophisticated. Looking back as well as they are mainly based on historical data. As a result, many standard risk models struggled to cope with the unprecedented effects of the COVID-19 pandemic. These included: sudden disruption of global supply chains, city closures, a juxtaposition of previously credible correlations between industry sectors and investment drivers, and the collapse of OPEC + which triggered violent reactions in the energy market and stock exchanges. To effectively manage long-term risks, active Investors can consider many scenarios and model cash flows to understand how companies will cope with long-term revenue shortfalls. Big data can help identify and address cluster risks – when groups of stocks that are not usually similar become correlated. Diversification can be adjusted to help keep your portfolio on track, even in the event of a conventional style and factor relationship breakdown. Combining fundamental firm analysis with a holistic view of how stocks, sectors and scenarios interact in new and unexpected ways can help Investors manage portfolio risk through a historic market event.

Avoiding the traps of excessive concentration of the investment portfolio

Benchmarks tend to be very concentrated when certain groups of stocks determine their value. For example, during the 1999 Internet bubble, tech stocks accounted for 33% of the S&P 500. When the bubble burst Investors who were overweight in the sector were severely battered. Currently, the five largest US stocks account for 22.6% of the S&P 500 index and nearly 37% of the Russell 1000 Growth Index. The market value of the 100 largest US companies is currently higher than that of all developed markets except the United States (measured using the MSCI EAFE method). These distortions can quickly disappear when the direction of the momentum changes.

Consistency and stability of the rates of return of the investment portfolio in the face of high market volatility

Investors would like to understand how their portfolio strategy will perform in the storm. Capturing highs and lows is becoming an increasingly popular measure for judging how much a portfolio will gain against a rising market and how much it will lose against a market decline. During the virus, these trends were put to the test. Some of the leading global indices did not perform as expected, while the average global equity fund was delivering the expected returns.

For example, the decline in the global MSCI volatility index was 86% during the COVID-19 crash in February and March 2020, while in previous downturns it was 57% of the market decline. As the markets rebounded in the following months, the MSCI World Value growth capture was significantly lower than usual at 84%, while the MSCI World Growth upward capture was significantly higher than usual at 114%.

Looking for winners in crisis markets

In the wake of the pandemic, which has caused enormous damage across sectors, industries and businesses, passive portfolios will include many stocks of companies that are under severe threat. Active managers can identify selected companies that are much more likely to withstand the pressure and perform well in the long run.

It has become more difficult today as COVID-19 caused unusually large discrepancies in various company metrics. Valuations, growth and profitability rates show huge differences between the highest and lowest forecasts. MSCI World Index earnings forecasts are now more divergent than at any time in the last 20 years. However, this dispersion creates fertile ground for active managers to find the most promising candidates based on research into business models, balance sheets, industry trends and management capabilities. In the past, when the profit spread was large, the world’s average active equity fund performed better than MSCI World.

Political risk: adapting to exogenous influences

We live in troubled times. Many countries are shaken by political polarization and instability, while geopolitical tensions are mounting. The US elections in November, Brexit and trade tensions between the US and China add uncertainty to a world struggling with the effects of the virus-driven pandemic and recession.

Political regimes have historically had minimal impact on the long-term trajectory of US stock markets. However, policy can have a profound impact on sectors, industries and businesses. Predicting political twists is extremely difficult. Stock-pickers need to be tuned to the potential of external shocks, such as political and regulatory decisions, which will have a disproportionate impact on some firms. Active managers have the ability and flexibility to adjust stakes that have become more vulnerable to political, geopolitical and regulatory risks, while benefiting from the actions of the beneficiaries of political decisions. On the other hand, passive portfolios leave investors fully exposed to sectors or companies that may be more affected by the political effects.

Controlling regional exposures in global allocations

For global Investors, market trends can distort a portfolio’s regional or country exposure. Due to the strong performance of the five largest US publicly traded companies, US equities now account for more than 66% of MSCI World compared to around 30% three decades ago. While there may be good reasons for Investors to overweight or underweight in certain countries, the passive portfolio may be overweight in countries that are relatively expensive. Active managers can adjust exposures per country to reflect the changing opportunities in individual stocks of companies, regardless of where they are based. This can foster a more balanced country exposure that is not affected by the performance of a particular country or region.

Sector ETFs can contain hidden risks

Technology and healthcare stocks were leading global markets until 2020. Naturally, many Investors seek to capture these strong performance trends in industry portfolios. However, in my opinion, doing this in passive sector or industry portfolios can be a risky approach.

Investing in ETF technology will provide a very large exposure to the largest companies with large capitalizations. For example, the two largest ETFs in the US have over 40% exposure to Microsoft and Apple. While these firms may offer good investment opportunities, high exposure to the biggest names can create disproportionate risk. Many other tech companies – including small and mid-cap companies – may also offer growth potential.

Passive strategies look backwards because in many cases companies that have performed well in the past are the most important. As a result, they are unable to really harness the innovative potential of smaller companies that could become winners tomorrow. Large ETFs may include some smaller tech firms, but are unable to increase exposure to smaller firms with great future potential, and in some cases cannot retain smaller firms that may not meet the requirements for inclusion in indices. For example, the largest technology ETF has over 300 stocks, but the top 10 shares account for over 60% of the assets. A proactive approach can provide a more balanced exposure to the sector without overburdening with a small number of very large companies.

Passive mode in investing is more active than you think

Just a decade after passive portfolios started to develop, Investors have more opportunities than ever before to buy passive exposure by region, sector, factor or trend. However, with so many passive ETFs to choose from, traders may be surprised to discover that even in the same category, not all ETFs are the same. For example, there are many different methodologies for creating ETFs that focus on high-quality stocks. Therefore, the spread of returns from the top 10 high quality US passive ETFs was 11.2% over the 12 months to September 22, while the spread between the most popular US low volatility ETFs was 14.6%. Similar trends can be seen in the passive portfolios of global and emerging markets.

Choosing a passive portfolio is actually an active investment decision. As the spread of returns within the passive category is often wider than the typical fee paid to an active portfolio manager in this category, we believe that the cost of the active management fee is reasonable, especially considering the many additional benefits an investor obtains by paying for an active portfolio.