The impact of financial deleveraging and the contraction of government spending in the developed world are likely to weigh on growth prospects for years to come. It is understandable that investors should seek to increase their emerging market exposure against this backdrop, but traditional long-only equity funds have frequently run volatility well in excess of indices.
Two broad options
So how do investors gain emerging market equity exposure without the volatility of traditional long-only global emerging market funds? In our opinion there are two broad routes to reducing volatility; first, to consider their equity investment strategy and, second, to use structured products to change the pay-off profile of an equity investment.
Traditional global emerging market equity funds are accompanied by volatility in the region of 30%. In comparison US equity volatility over the past five years has been approximately 19%. More considered portfolio construction can reduce volatility – one popular strategy has been to select developed market stocks which generate a high proportion of their revenue from emerging markets. Perhaps a more interesting strategy is to seek equities bearing high dividend yields.
Dividend strategy
Many emerging market equity funds consider the growth of a company’s earnings far more important than the dividend. This may be a mistake for two reasons: first, dividend strategies tend to carry a lower beta; and second, if Asia is a guide, historical returns to a dividend strategy may be higher.
Comparing the beta of high dividend indices globally, it seems that most have had a beta of between 0.75 and 0.9 since the turn of the century (with only a brief period of much higher correlation during 2009-10).
The graph below illustrates this point in Asia, comparing the beta of the MSCI Asia ex Japan High Dividend Index against the MSCI Growth Asia ex Japan Index. The difference between growth and broad indices in volatility terms is around 2-5%. The lower volatility may be consistent with the nature of the type of stocks that generate high yields.
Deep value business
Although it may be a dangerous generalisation, high dividend yielding stocks may have this lower volatility characteristic because they are more mature businesses, generating excess cash flow relative to their growth needs. The other possibility is that they are deep value businesses, in which case they may exert less influence on overall indices.
While the former category may be considered dull to some emerging market managers, these companies are also likely to have exposure to the underlying economic growth. While the deep value companies may be more volatile, if properly evaluated they could offer superior returns.
Second, and as the graph indicates, high growth stocks have typically underperformed. This has been highlighted in recent Citi research, which shows that the top quintile of growth stocks underperform the top quintile of dividend yielding stocks in Asia by approximately 5% per annum since the turn of the century. This may suggest that there is too high a premium for growth stocks or simply that returns are crowded out. The power of compounding dividend returns should not be overlooked either – reinvesting income can be easily overlooked when comparing prices as a rough and ready measure of returns.
Another strategy that has been widely used to enhance income is a covered call strategy. These have been around for some time and involve owning a portfolio of stocks and continually writing (selling) call options on those stocks. Investors receive a premium for this that is accrued or paid out as an enhanced yield.
Downside cushion
Naturally, by writing call options investors are limiting their potential upside gains, but if the goal is to reduce volatility, these strategies provide a downside cushion equal to the premium received for selling the option. In emerging markets, where volatility is higher, this can be profitable. This strategy is reliant on the availability of options and with exchange-traded derivative markets in emerging markets far less developed, liquid and accessible to investors, access to derivative or tailored strategies is arguably better achieved via structured products.
Structured products can provide alternative tailored solutions or complement investors’ existing exposure to long-only equity funds. Their potential use within portfolios is often greatly undervalued given how flexible these investments can be. One of their primary uses is that of adjusting the risk/return profile of a given investment to suit that of the investor or portfolio, so it stands to reason that managers would look to use them when looking to decrease risk.
A fully or partially principal repayment note linked to the desired underlying markets is the simplest structure. However, given the low interest rate environment and relatively high volatility in emerging equity markets, investors may have to extend the duration of these notes to five years or more in order to pick up value.
Shorter tenors offer significantly reduced participation or require low caps (such as low maximum returns) in order to provide a feasible return profile. Given the absent or limited downside optionality of these notes, volatility will be greatly reduced relative to that of the underlying asset.
Reducing risk
Putting full principal repayment aside, investment options are more varied as investors receive premium for selling downside risk, which can be used to deliver more upside returns – principal repayment structures rely solely on the funding provided by the issuing bank.
Also, by limiting (positive) returns, investors can significantly reduce their downside risk, for example: using an AA-rated counterparty, a two year US dollar-denominated note linked to the Hang Seng China Enterprises Index would provide 100% upside participation but only to a maximum return of 20% (9.5% pa compounded), while capital is only at risk from beyond a 45% fall in the index.
Put simply, the investor can benefit from an appreciation of the index, but only has to bear a loss on the index below 55% of its initial level. This can be seen in one of two ways, either as protecting the investor against the first 45% fall in the index, or as owning the index at 55% of its initial level. Investors may miss out on profits beyond 20%, but a potential 9.5% pa return is appealing given the level of risk/volatility reduction.
A third variation of product to consider is the ‘autocallable’ note. These come in all shapes and sizes but typically redeem annually in the event that the underlying asset trades at or above a pre-defined level.
In this circumstance the note returns full principal and a pre-set cumulative coupon for each year passed prior to call or maturity. Principal is protected provided the underlying is not trading below a threshold level at maturity but investors are exposed to full downside losses if it is.
Optimising returns
In most scenarios, the mark-to-market volatility of these notes will be lower than that of the underlying asset. Investors should, however, be aware that as the underlying moves closer to the threshold level and market volatility increases, so will the volatility of the investment.
That said, they are still a more than able alternative to long-only funds, particularly when you consider that they optimise the probability of return by requiring that the underlying asset only trade at a given level (usually the initial level) for investors to profit.
Longer tenor autocallable products offer more value and flexibility with regards to adjusting one’s risk/return ratio, and defensive autocallables – where cumulative coupons are paid at maturity should the underlying be at or above 50% or 60% of its initial level (at maturity) – are certainly more interesting for those with less conviction in the direction of markets in general.
It is clear that investors have several options available to maintain emerging market exposure without necessarily experiencing all the volatility associated with traditional emerging equity funds.
