The Benefits of a Long/Short Strategy in Emerging Markets

A long-short equity strategy is a different way of accessing this asset class and it has several advantages. In particular, it's better positioned to take advantage of inefficiencies that we see in this space. These inefficiencies arise from a variety of different sources, in no particular order, there's no single smoking gun, but rather a confluence of a lot of reasons that kind of keep these inefficiencies interesting and very much alive, right? Some of those have to do, for example, with the fact that these are different countries, different markets, so there are impediments to the free flow of capital across these countries, which in turn make the incorporation of prices and information slower than what investors are used to seeing in the developed markets.

So, for example, certain insights that in the US developed markets, they get arbitraged after a few hours. They still work in emerging markets a few weeks after they come out to the market. So that's the magnitude of the inefficiencies we're dealing with here. Some other inefficiencies arise, for example, from very large, I think it's large for investors' perspective, large transaction costs in this space, large enough that they keep the barriers to entry high, and that in turn keeps the inefficiencies up there for investors that can actually access the asset class.

So those are definitely some of the inefficiencies. Other have to do with how you collect data, how you process data for these markets. They also add to the different levels of inefficiencies.

Now another advantage from a long-short approach has to do with mitigating volatility. Volatility in emerging markets, according to the Index, has been very large. The largest drawdown was recently about four years ago during the large financial crisis, the global financial crisis, when there was a large max drawdown of 60 percent. That is real. People experienced that, lived through that. Even in a year like this, 2012, as of October of this year the EM Index was up eight percent through a roller coaster ride when it was up in January-February, down 11 percent in May. So that actually translates in the annualized volatility of around 18, 19 percent. A long-short strategy can mitigate most of that volatility by being short most of the Index exposure leaving you with the extraordinary return, alpha return as we like to call it, without the pain or the problems associated with a large volatility induced by the large beta component in a lot of traditional strategies.