Point of View With Jeff Shen and Rodolfo Martell
While equities have offered excellent opportunities for returns, they have come at the cost of volatility. We speak with BlackRock's emerging markets experts about a way to access equity returns while mitigating the risks.
- Unprecedented global market events and extreme volatility have created an aversion to equities that has left many portfolios lacking the ability to generate meaningful returns.
- A major factor in this shift away from equities is that portfolios are overweighted with market risk, which magnifies the volatility caused by extreme market events.
- A solution is to incorporate an investment strategy that helps reduce market-related volatility, has a low correlation to traditional equities while capitalizing on inefficiencies of equity markets.
- Inefficient emerging markets are ripe with opportunities given that data is scarce, information is priced slowly and companies operate with different governance and accounting standards.
How can equity investors access returns while mitigating the extreme volatility?
Investors today need to think more holistically and globally about their equity portfolio. By this we mean reconsidering the sectors that they are invested in as well as the strategy they use to access those equity sectors. For example, we believe that investors should consider emerging markets for return opportunities and alternative strategies to mitigate the extreme volatility that equity investors have endured over the past decade.
What are the advantages of having an allocation to emerging markets?
With investors starved for returns, emerging markets offer tremendous opportunities. Given that the average US investor, with only a 5% allocation, is considerably underweight the sector, demand for emerging markets assets should remain strong for some time.
"We believe emerging markets will remain the fuel for world growth, consumption and wealth creation over the next decade and beyond."
Furthermore, we believe emerging markets will remain the fuel for world growth, consumption and wealth creation over the next decade and beyond. However, investing in emerging markets has exposed investors to substantial volatility and risk, motivating us to look for a better way to invest in these regions. Several secular themes are driving our views, including emerging markets population growth and expansion of the middle class, both of which are positive internal economic and consumption drivers. Furthermore, we believe emerging markets GDP and wealth accumulation have great long term growth potential based on growing emerging markets exports and commodity production. Emerging markets' share of world stock market capitalization greatly lags these countries' contribution to the global economy. They account for nearly 50% of world GDP (and growing), more than 50% of world energy consumption, more than 70% of total land mass and greater than 80% of world population. The equity markets in these regions have great capacity for growth, underscoring our view that the investment potential can be exceptional.
Within this context, however, investors should be alert to the risks of emerging markets and smaller capital markets investing. They include risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments.
Are emerging stock markets efficient and reliable like those in the US?
No. In fact, as professional investors, one of the things we find most attractive is the information inefficiency of these markets. Reliable, good-quality data is scarce. One of the key advantages of our platform here at BlackRock is our ability to scrub and clean the data to prevent a "garbage-in, garbage-out" scenario, which could hurt a manager with lesser resources. The deficiency of data means that information is priced in slowly across emerging markets, which can be a big advantage for sophisticated investors. For example, information is factored into equity prices in developed markets, such as the US or Japan, in a matter of minutes or hours. In emerging markets, it can take days, weeks or even months for information to be priced into securities. Our portfolio management team is immersed in market and security research and can often capitalize on an event before the market prices in its realization. The chart below shows how slowly information gets arbitraged away in emerging markets (three months), versus how quickly in the US (30 minutes). That's a powerful example of the potential inefficiency in this market that makes us very excited about investing in emerging markets.
One of the main concerns investors have had with emerging markets has been their higher risk profile relative to developed markets. What is your perspective?
While this elevated market risk is real, investors should not lose sight of the tremendous opportunities for investing. In response to the risks and opportunities, we have developed a unique and we believe better way to invest in emerging markets, through a fundamentally-driven, systematically implemented long/short equity strategy. This kind of strategy seeks to neutralize the volatility and market risk while focusing on the enhanced returns from specifically researched and picked investments (see chart above).
What do you mean by a long/short strategy?
A long-short equity investment strategy means that we buy (long) stocks that we believe will appreciate in price, and at the same time sell (short) those stocks we believe will go down in price. This type of strategy seeks to avoid macro risk where the entire market goes down and impacts the portfolio, and take advantage of the stocks chosen through our fundamental research process. The example that we like to use compares the relative returns between Korean Car Company A versus Korean Car Company B. We're not trying to make a bet on Korea. We're not trying to make a bet on the auto industry. We are trying to figure out whether Korean Car Company B is an outperformer or underperformer relative to Korean Car Company A. In this example, we would look at 20 stocks within the Korean auto sector and rank them from one to 20. We would go long the stocks that we like, those ranked high; and we would go short the stocks that we don't like, those ranked low.
Your approach is unique in the marketplace. How does it mitigate volatility?
A dedicated long-short approach is a very efficient way to access these markets because it allows us to mitigate market risk within the portfolio.
A dedicated long-short approach is a very efficient way to access these markets because it allows us to mitigate market risk within the portfolio. By matching both long and short equity positions, we have the ability to dial up or down our exposure to market risk from 0% ("market neutral") up to 40% exposure. This means we seek to deliver above-market, excess returns (referred to as alpha) out of our investments, while minimizing our overall exposure to market movements (referred to as beta). Investors should note that long/short strategies present the possibility of larger losses than invested capital, and that the long and short strategies may not perform, potentially adding to volatility and losses.
This strategy is not about hitting home runs. It's about achieving a continuous succession of singles that ultimately brings the investor attractive returns with minimal risk. Such a strategy can offer low correlation to international stocks, US stocks or even bonds, presenting a valuable source of diversification and risk-adjusted returns. At the same time, diversification strategies do not ensure a profit and may not protect against losses in a down market.
As managers, we seek low realized volatility relative to the index, as you can see in the chart below. Also, we seek a higher Sharpe ratio, which is the amount of return per unit of risk. The greater the Sharpe ratio, the better the risk- adjusted performance. In summary, the long/short, low volatility approach is designed to outperform long-only, high beta strategies on a risk-adjusted basis.
Describe your investment process and how you choose the best investments?
Our approach is a fundamental, bottom-up stock picking approach that we implement systematically. Because emerging market stock-specific risks are essentially the same as developed market risks (see chart below), we prefer to look deeper at the specific stock level to make investments. We rely on three main measures of value in picking stocks to own or to sell short: earnings quality, sentiment and relative valuation. Our process is agnostic in terms of having favorite countries or favorite industries. We do an enormous amount of work to collect the data on earnings quality, sentiment and relative valuation because they form the basis for our rankings and thus our buy/sell decision. We have a unique ability to analyze vast sources of unstructured data. With all these factors, we get a comprehensive view of how likely it is that a given stock is going to outperform its peers over the next three to 12 months. The portfolio management team uses that output to construct portfolios.
Tell me about your team?
The emerging markets equity team has been together since 2003. We think about the team as a bit of a sea turtle in the sense that we can walk on the global ground, but also swim locally. We have team members in Asia, Europe, Australia and the US, and we go to the emerging market regions quite often. So we really try to get the best of the blend between global and local.
How important are size and scale in emerging markets investing?
The best way to capture those three insights that we mentioned earlier—value, quality, sentiment—is through a large-scale effort. In fact, we have approximately 50 individuals that support the core 12-professional portfolio management team. Our investment team is located around the globe, so the sun never sets on our ability to manage the portfolio.
How should an investor incorporate this strategy into their portfolio?
Given the importance of the emerging economies to global growth going forward, we believe most investors should add some level of exposure to the space. Incorporating a long/short strategy would offer a complement to traditional long-only developed markets or emerging markets strategies given the differentiated source and pattern of returns of this approach. While the "typical" investor's portfolio has increased the allocation to emerging markets, it still holds only 5% in emerging market equity according to Lipper, considerably underweight the 12% that EM represents in world market capitalization. However, we believe that allocation is even too low, given the attractiveness of emerging markets from a fundamental and growth perspective. Indeed, the asset class could potentially offer double the earnings growth and triple the GDP growth, with only half the corporate debt and a quarter the sovereign debt.As such, we suggest clients consider an overweight 18% exposure to emerging markets. Each individual's ideal recommendation will be different based on age, risk aversion and time horizon, and this decision should be made with the guidance of a financial professional who is familiar with each individual's unique needs and preferences.
- Investors underweight equities and avoiding volatility can use a dedicated long/short strategy to increase opportunities for excess returns while reducing market risk.
- Investors seeking enhanced diversification can use a non-traditional long/short strategy to profit from both positive (long) and negative (short) views, generating uncorrelated returns to other holdings.
- Investors seeking to capitalize on the growth within emerging markets. Opportunities within emerging markets are plentiful, especially for active managers since information is priced slowly and reliable data is scarce.
Stock values fluctuate in price so the value of your investment can go down depending on market conditions. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments in emerging/developing markets or smaller capital markets. Long/short investing entails special risks. Short sales in securities that increase in value can cause a loss of principal. Any loss on short positions may or may not be offset by investing short sale proceeds in other investments. Investing in derivatives entails specific risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investmentstrategy. The opinions expressed are those of the portfolio manager profiled as of November 12, 2012, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
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Prepared by BlackRock Investments, LLC, member FINRA.
Luiz Soares & Jeff Shen
BlackRock's emerging markets experts discuss opportunities, misconceptions and ways of incorporating the asset class into your portfolio.