Portfolio construction

Allocating to emerging markets? Consider these factors.

April 26, 2024 - 6 min read

Vladislav V. Grigorov, CFA^®

Portfolio Consultant - Natixis Investment Managers Solutions

Sean Kaukas, CFA^®

Portfolio Consultant - Natixis Investment Managers Solutions

There are a variety of well-known reasons to have a constructive long-term view on emerging markets assets. The promise of higher economic growth rates, burgeoning urban populations, and the ascent of a thriving middle class are all catalysts that have driven investors to consider strategic allocations to emerging markets in their portfolios. While the case for broad emerging markets exposure can be straightforward, the implementation in a balanced portfolio is more nuanced. Emerging markets allocations can be expressed in equities, fixed income, or a combination of both. When deciding the appropriate mix for a portfolio, there are important considerations to keep in mind.

Regional exposure varies

Emerging markets investing looks different depending on whether you invest in equities or fixed income. If you invest in an equity product benchmarked to a broad market index, such as the MSCI EM, you can end up with a very chunky unintended exposure to a small group of countries as shown in Figure 1. The top five countries in the MSCI EM make up approximately 80% of the index, with China representing roughly a quarter. The picture changes substantially in bonds.

Figure 1 – Composition of emerging markets indexes

Source: Natixis Investment Managers Solutions, MSCI, JP Morgan

In emerging markets government bonds, there are two broad flavors, represented here by two ETFs.

EMLC – Tracks the JPM GBI-EM Global Core Index and represents sovereign local currency issuers.
EMB – Tracks the JPM EMBI Global Core Index and represents sovereign USD bond issuers.

Both bond flavors are more diversified from a regional perspective than the emerging markets equity index. This is, in part, due to a 10% cap built into the index construction methodology by JPMorgan.

Pay attention to currency risk

When investing in emerging markets, you’re taking on currency risk. This currency risk differs meaningfully across equities and fixed income. Looking at currency risk within the EM debt space, investors commonly make the decision to allocate to either of the two broad flavors we referenced above.

While EMB doesn’t have direct currency exposure, it’s fair to say that the credit risk of these bonds is affected by fluctuations in their currency. If the USD strengthens, relative to an EM currency, debt servicing costs increase in terms of the local currency. EMLC, on the other hand, has direct currency exposure as these sovereign bonds are denominated in local EM currency. The currency translation effect is reflected in a US-based investor’s return.

This currency translation effect is reflected in a US-based investor’s return for emerging markets equities as well, and the impact can be substantial. You can see this impact on returns in Figure 2, where we show performance for MSCI EM USD (returns for a USD-based investor), vs. MSCI EM LCL (returns for a local currency investor) for periods when the dollar price index (DXY) is rising and falling.

Figure 2 – The impact of currency translation

USD price index (3/29/2019–3/22/2024)

Source: FactSet

While there may be an appetite to hedge this currency risk, hedging is typically cost prohibitive. While you may not see currency hedging reflected in the expense ratio of the fund or ETF, it certainly adds to the costs of running the portfolio and will show up as a drag on returns in stable currency environments. A screen in Morningstar of the equity funds and ETF universe shows 322 products in the “Diversified Emerging Markets” category, with only two of them hedging currency exposure. A Morningstar screen of the emerging markets bond funds and ETF universe does not show any currency-hedged strategies.

Caution: Credit quality may vary

It’s also worth noting that within the bond space, there is a meaningful difference in credit quality, depending on the broad flavor of EM sovereign debt you choose. Emerging markets’ local currency issuers are widely recognized as higher quality than their USD-issuer counterparts for two reasons:

Local currency issuance is safer for the issuer, since falling currency, relative to USD, does not negatively affect the issuer’s ability to repay principal and coupon in their own currency.
There is enough demand for currency of the issuer, implying a stronger economy and ability to service debt.

Figure 3 shows the credit quality of the two EM debt ETFs we’ve been referencing. You can see that roughly two-thirds of EMLC is investment grade quality, while only half of EMB is investment grade.

Figure 3 – Credit quality comparison

What about the diversification benefits?

We’ll finish up by highlighting the potential diversification benefits of allocating to a combination of emerging markets equity and debt in a portfolio. Let’s assume an investor, who is constructive on both EM equity and debt is considering the following changes to a 60/40 portfolio. Portfolio holdings are proxied using benchmarks. The proposed changes include adding 5% to MSCI EM and 5% to JPMorgan EMBI Global Diversified, sourcing from the S&P 500® Index and Bloomberg US Corporate BB, respectively (Figure 4).

Figure 4 – Adding EM equity and debt allocations

While the investor believes that these EM equity and debt allocations will outperform their respective allocation sources, there is the risk that one or both underperform. However, historical return and credit spread data suggest that the relationship of their excess returns is quite weak. Put another way, if the EM equity allocation underperforms the S&P 500^® Index, this doesn’t necessarily mean that the EM debt allocation is likely to underperform as well.

Evaluating the risks

We prove out this point by analyzing roughly 13 years of returns for the S&P 500^® and MSCI EM indexes, and credit spreads for the Bloomberg US Corporate BB and JPMorgan EMBI Global Diversified indexes. We use credit spread data for fixed income to neutralize the duration impact to return. The regression between the time series indicates whether two asset classes have a propensity to outperform/underperform at the same time:

Time series 1: Excess return of MSCI EM vs. S&P 500^® Index –> Positive value = EM equity outperformance
Time series 2: Excess spread change of JPMorgan EMBI Global Diversified vs. Bloomberg US Corporate BB –> Positive value = EM debt outperformance

As the scatter plot in Figure 5 demonstrates, there is a positive relationship between the two series, but with an R-squared of just 0.13. This result indicates that EM equity and debt do not reliably underperform (or outperform) comparable asset classes at the same time. Therefore, the risk this investor is introducing may be less than what appears on the surface.

Figure 5 – EM equity and debt historical performance relationship
EMD/BB vs. EM Equity/S&P 500 (1/31/11–3/29/24)

Source: Natixis Investment Managers Solutions, FactSet

Navigating emerging markets investments requires a nuanced understanding of regional exposure, currency dynamics, credit quality, and the potential diversification benefits. We recommend carefully considering these factors when implementing an emerging markets allocation. By doing so, investors can better position themselves to benefit from the long-term potential of emerging markets assets.

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The views and opinions (as of April 8, 2024) are those of the author(s) and not Natixis Investment Managers or any of its affiliates. This discussion is for educational purposes and should not be considered investment advice. There can be no assurance that developments will transpire as forecasted, and actual results may vary.

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