Emerging Markets as a Whole

I recently wrote an article on the emerging markets across the globe, and looking at the charts of performance for each country, I couldn’t help but notice one thing. While magnitude of volatility varied from country to country, every chart had the same shape. Every trend line moved together. MSCI Barra provides charts of the individual emerging markets based on the listed equities of each country. Each emerging market was booming up until 2008, took a sharp decline in the middle and end of 2008, and bounced back at the beginning and middle of 2009, which probably isn’t surprising to anyone reading this. “Some of emerging markets hedge funds were down almost 50 percent,” according to Andrew Schneider, managing partner of HedgeCo Networks. “Take the Tarpon All Equities Fund for example. They lost 43 percent in 2008.” While this type of volatility is expected in the emerging markets universe, fund managers and investors don’t have to withstand these massive losses to access the spectacular gains of better years.

The Emerging Markets Market

Because each country’s equity market moved in such a similar pattern, I began to think we could start looking at the whole basket of emerging markets as a unique market, like the US equities market. The broad movements imply market or systematic risk. When the emerging markets market (EM market) moves, individual emerging markets face pressure to move in the same pattern.

The movements of the emerging markets as a whole are mainly due to foreign investors’ capital moving into and out of the EM market based on the perception of emerging countries in general or as emerging market investors’ capital is fluctuating, which was the case in 2008. Investors in developed countries lost money domestically and liquidated their foreign holdings. These types of fluctuations are artificial, since a country’s economy does not become less productive and innovative just because foreign investors are pulling out capital. I would equate these artificial movements to a stock that loses ten percent market value when it misses its earnings forecast by a penny.

Trading Countries

If we can look at the emerging markets as a whole and come to the conclusion that it is indeed a market, investors can view each emerging country as a distinct security. Because there is a market made up of securities, investors can apply statistics to create beta and correlation coefficients, which describe the relationships between individual securities and the market.

Investors now have the fundamental pieces for comparing emerging countries to each other. We can begin to look at countries as overbought and oversold, highly correlated or uncorrelated, and outperforming or under-performing. This type of analysis is essential to modern portfolio theory.

Neutralizing the Emerging Markets Market

If the investors have access to the EM market and can compare and value individual emerging countries, potentially there is opportunity to build a market neutral emerging market portfolio. Investors could put a long position on one emerging market through ETF’s, individual equities, bonds, commodities, and currency and take short positions on another emerging market. If the long position outperforms the short position, a collapse in the EM market shouldn’t affect the portfolio value, as this position essentially captures gains on one market outperforming the other. “What we have here is a method for investors and fund managers to reduce their risks,” adds Evan Rapoport, CEO of HedgeCo Securities. “By utilizing paired trades, hedge fund managers and investors alike can invest in the emerging markets with a diminished downside.”

I back tested a paired trade of two emerging markets over the past four years. My simulated portfolio produced 28.38 percent average annual returns for the four year period ending on August 20, 2009. Over that same period, the emerging markets as whole returned 9.84 percent per year on average. Here are some statistics describing the monthly returns of my simulated portfolio, the two underlying assets of the portfolio and the emerging markets market.

As you can see, there are significant risk reductions by producing my paired trade over the emerging markets as a whole. This suggests that the market neutral position is reducing risk more than diversifying across a large basket of assets. Furthermore, the reduction in downside deviation in the simulated portfolio allowed the portfolio to outperform its top performing asset (the long position in Country X produced an average annual return of 27.62 percent) over the four year period.

Conclusion

This is a new way to look at investing in emerging markets. Rather than trying capitalize on soaring returns in a volatile market, investors can look to hedge their emerging market positions against one another and capture more stable returns. The growing popularity of emerging markets almost certainly will provide more opportunities for foreign investors to access emerging markets and lead to the development of more sophisticated exchanges to facilitate trading emerging market securities. Furthermore, this increased efficiency in trading should lead investors and fund managers into applying many of the traditional trading strategies in the emerging markets. It will be interesting to see which trading strategies prove to be profitable when applied to emerging markets.

Tags: Beta, Correlation, Emerging Countries, Emerging Market Strategy, Emerging Markets, Emerging Markets Market, hedge fund, Hedge Fund Strategies, Investing Strategies, Investors, Market Neutral, Not Categorized, Paired Trade

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