By Susanne Willumsen
Low volatility and emerging market equities are terms rarely found in the same sentence. However, a low volatility portfolio of emerging market equity investments may produce a smoother return pattern when contrasted with a market weighted benchmark or even a style-specific approach.
Such a strategy can help serve to mitigate the entry point risk and provide an opportunity to increase in allocation to emerging markets without necessarily changing aggregate portfolio risk. In addition, a low volatility allocation in emerging markets leads to more diversified economic exposures, such as more evenly disbursed sector weights; a cap-weighted benchmark tends to concentrate weightings in a few sectors and relatively few stocks.
Long-term investors have been more than rewarded with additional returns by assuming the risks of emerging market investing. Therefore, one might conclude that investing in higher risk emerging market stocks will surely lead to outsized returns compared to lower risk stocks. To test this hypothesis, we looked at the returns of high and low volatility stocks since 2000, with volatility calculated as daily price volatility over the previous 12 months. Linking a monthly set of returns for the most volatile and least volatile quintiles of stocks (equally weighted) from 2000 (the inception of the revised MSCI Emerging Markets Index) actually showed the opposite. In fact, there was a meaningful premium from investing in low volatility stocks. While turnover and transaction costs were not reflected, it is clear that, based on analysis over this period, there is a performance advantage in favour of low volatility stocks.
An issue in emerging markets equities is the long history of repeated speculative bubbles, which typically correct themselves in a sudden and painful manner, often to investors’ dismay. Country and industry concentrations have routinely dominated the capitalisation weighted benchmarks through time and corrections can be both significant and painful. For example, the collapse in commodity prices has reduced the market index weight in materials by 30% in just the past 12 months. This same concentration also applies at the security level where today nearly 20% of the index is weighted in the top 10 companies. A low volatility portfolio tends to maintain a consistent, diversified exposure to sectors which are typically more stable and evenly distributed than the capitalisation benchmark. By maintaining a consistent exposure to sectors, an investor is less susceptible to such speculative excesses that can dominate a capitalisation weighted benchmark. Trading off systematic risks (interest rates, commodity prices) for stock specific risk can help to reduce overall risk while still allowing for the desired growth expected of emerging markets investing.
Another significant benefit is that the pattern of returns is differentiated from most emerging market managers. Without sacrificing long-term returns, such a strategy offers lower volatility and correlation to most emerging market equity approaches. The return pattern occupies a distinct point in the emerging market universe and is not easily duplicated by defensive or value oriented managers. For investors who are risk budgeting, an allocation to such a strategy can provide an opportunity to either permit an increase to emerging markets and/or reduce total portfolio risk without impacting long-term return expectations.
A low volatility strategy may also help mitigate entry risk. It is always difficult to commit to an asset class that has experienced such an extraordinary run. Low volatility strategies are designed to help mitigate losses in difficult market periods, partially insulating the investor from a poor entry point. At the same time, a low volatility strategy is designed to participate in a significant portion of the upside gains in the event of a sharp rally.
Susanne Willumsen is a portfolio manager at Lazard Asset Management
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