This is a sponsored article from Goldman Sachs Asset Management.
Goldman Sachs Asset Management (GSAM) has been managing dedicated emerging market (EM) mandates for over twenty years, during which time we have seen a significant deepening of capital markets and a growing number of regions opening up to foreign investors. The investable EM universe has grown to over US$10 tn, with over 2,500 securities1. We see three key components of success for investing in EM:
- Be diversified: A comprehensive approach, which allocates across equity and all sectors of debt, may help to improve risk-adjusted returns by reducing exposure to a particular region or source of risk
- Be flexible: The ability to interpret and adapt to changing conditions is key to both navigating risks and identifying sources of alpha
- Be selective: The proliferation of EM sovereigns and corporate issuers make a compelling case for outsourcing investment decisions to well-resourced EM active managers with strong research capabilities dedicated to EM
EM investment opportunities are as varied as the languages, climates and cuisines of the home countries. The EM universe has expanded far beyond the well-established avenues of equity and dollar-denominated sovereign bonds. Within emerging market debt (EMD), issuance of US dollar-denominated debt is surpassed by local currency debt. The ascent of local currency assets reflects the deepening of EM financial markets. From an investment perspective, the choice between US dollar and local currency debt adds another dimension to an already diverse investment landscape.
EM growth has, on average, been 50% higher than that of developed markets (DMs) since 1950 but 80% more variable2, with more frequent episodes of volatility due to a combination of factors including geopolitics, commodity price fluctuations and credit or monetary shocks. As such, it is imperative to diversify across EM regions to avoid concentration risk. For example, as illustrated in Exhibit 1, EM Asia is a large proportion of the EM Equity Index, while Latin America has the highest regional weighting in EMD indices. Our research demonstrates that regional diversification can materially improve long-term risk-adjusted returns.
We evaluate historical risk and return characteristics of each EM asset class, using both quantitative and fundamental analysis, to ultimately derive the optimal allocation across drivers of return. These drivers include interest rates, currencies, credit or equities.
Exhibit 13 – Be diversified across regions to avoid concentration risk: Comparison of the regional variations between EME and EMD benchmarks
Given the wide range of factors that interact to drive growth and determine value across and within EM, we believe that a flexible approach to portfolio construction is necessary to optimise performance. Long term correlation analysis disguises the significant range of returns which exists between the top and bottom performing sectors of EM. In Exhibit 2 we illustrate performance across various EM sectors over the last decade, and find that dispersion in performance can be volatile, ranging from a high of 57% in 2009 to a low of 1.9% in 2016.
Exhibit 24 – Be flexible as no single asset class out-performs every year: Ranked EM asset class performance5
To guide positioning against this backdrop of potentially highly dispersed performance, we have developed a framework that is centred on three core components:
- a. The global business cycle: We use macroeconomic analysis to evaluate the health of the global business cycle and adopt a growth oriented or defensive allocation accordingly. At present, the global economy is healthy and we expect the synchronised expansion to continue, with EM growth accelerating. In turn, we are overweight EM equity — which tends to be more growth sensitive — relative to EMD.
- b. Cross sector views: Within fixed income, we combine fundamental and technical analysis across EM local and US dollar-denominated debt, currencies, and corporate credit to identify mispricings and relative value or opportunities. We are currently underweight US interest rate risk as we expect higher inflation to result in further US monetary tightening, while we are overweight emerging market currencies versus the US dollar, as they offer attractive carry6.
- c. Country views: The macro health of countries exerts significant influence over the performance of sovereign debt and currencies. We therefore seek to examine a country’s fiscal position, balance of payments profile and monetary policy outlook.
Disparity in manager performance highlights that market and informational inefficiencies exist for active managers to take advantage of. Exhibit 3 outlines the trailing annualised excess return for top-quartile managers in the MercerInsight EM, DM equity Universe. A top quartile manager in EM has delivered greater returns than an equivalent quartile manager in global DM equity for all time horizons.
Exhibit 32 – Be selective – a top quartile EM equity manager is historically able to out-perform a global DM equity manager7 for all time horizons
Benchmarks that are weighted by market capitalisation can be backward-looking with overweight positions in yesterday’s winners and underexposure to growth opportunities of tomorrow. As such, EM investors should seek active managers who pursue investment opportunities beyond the benchmark universe to maximise return potential, while avoiding less attractive index constituents.
The EM Equity Index is comprised of 800 companies, 80% of which are directly or indirectly exposed to mega- and large-capitalisation companies, and 28% to state-owned enterprises (SOEs). The active approach of our equity team involves allocating around one half of the portfolio to off-benchmark small- to mid-sized capitalisation companies from an expansive universe of over 6,000 companies, many of which reside in younger, more domestically-oriented sectors such as consumer discretionary and healthcare (see Exhibit 4). The team widens the security selection universe further with the inclusion of EM corporate debt, gaining exposure to over 550 issuers across over 50 countries from an array of sectors. Over 60% of this sector is investment grade rated, therefore providing access to high-quality yield. Issuers in this universe also tend to have lower interest rate sensitivity than similarly rated DM counterparts.
Exhibit 4 – GSAM’s active approach enables the allocation to off-benchmark small & midcap companies to gain high-quality yield.
Sector breakdown of MSCI EM large cap and MSCI EM small/mid cap8
We therefore believe that investors looking to access long term opportunities in emerging markets, while navigating a bumpy ride along the way, should consider the avenue of multi-asset investing. We see value in a well-resourced multi-asset manager, with the capability to manage a portfolio that is well diversified, flexible, and selective in the risks it takes to access this opportunity9.
2 Source: GSAM, GPS team, based on annual data from 1950-2014, comparing 18 EM countries vs G10 in DM.
3 Source: GSAM, Bloomberg JPM EMBI index for Emerging Market Debt, MSCI EM for Emerging Market Equity. As of December 2017
4 GSAM, As of Dec 2017. Past performance does not guarantee future results, which may vary. All returns in USD. EM Equity – MSCI World, EM Sovereign Debt – JPM EMBI GD, EM Local Currency Debt – JPM GBI-EM, EM Corporate Debt – JPM CEMBI BROAD DIV.
5 Past performance does not guarantee future results, which may vary.
6 As of March 2018
7 Past performance does not guarantee future results, which may vary.
8 Source: Factset, as of May 21, 2016.
9 Diversification does not protect an investor from market risk and does not ensure a profit.
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Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.
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Emerging markets securities may be less liquid and more volatile and are subject to a number of additional risks, including but not limited to currency fluctuations and political instability.
Investing in the N-11 countries is subject to risk of loss due to adverse social, political, regulatory or economic events in those countries. Investments into the N-11 countries may have to be implemented via equity swaps, equity index swaps, futures, participation notes, options and other derivatives which may involve additional financial counterparty risk. Changes in exchange rates may materially impact the value of investments in the N-11 countries. Financial advisers generally suggest a diversified portfolio of investments. Whilst the N-11 countries have some diversification in themselves, there may be times when these markets are all impacted in parallel by the same factors, which may make an investment in N-11 more volatile than a more diversified investment and an investor should only invest if he/she has the necessary financial resources to bear a complete loss of this investment.
Foreign securities may be more volatile than investments in U.S. securities and will be subject to a number of additional risks, including but not limited to currency fluctuations and political developments.
Indices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices. The indices referenced herein have been selected because they are well known, easily recognized by investors, and reflect those indices that the Investment Manager believes, in part based on industry practice, provide a suitable benchmark against which to evaluate the investment or broader market described herein. The exclusion of “failed” or closed hedge funds may mean that each index overstates the performance of hedge funds generally.
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This is a sponsored article from Goldman Sachs Asset Management.