To financial advisors, exposure to emerging markets is a means of gaining essential diversification for clients' portfolios. At a time when growth is muted in the U.S. and elsewhere, emerging markets have the potential to drive returns, further helping clients achieve their investment objectives.
But committing to emerging markets hasn't been easy, on either advisors or their clients.
Some advisors are disappointed with the results and effectiveness of their approach thus far to emerging markets. Others have avoided the allocation altogether, hoping against their better judgment that the next decade will be a repeat of the last decade.
For an understanding of advisors' views on the role of emerging markets exposure in clients' portfolios, Calamos Investments sponsored a survey by DST kasina Advisor Insights in partnership with Horsesmouth. The research was conducted in February 2016, as the markets were recovering from the early 2016 volatility and prior to the spring rally in emerging markets.
EM As A Core Portfolio Allocation
More and more of the world's growth will happen in emerging markets, we believe. The days of waiting and seeing are over. Financial advisors, their clients and prospective clients understand this by now, too.
Six out of 10 (61%) of advisors consider emerging market equity a core portfolio allocation.
And, 63% of advisors surveyed said they used EM equity as a component of a strategic asset allocation.
The levels of the allocations at the time of the survey, however, were significantly less than the maximum allowed by advisors’ investment policy statements or other policies that restrict portfolio positions.
EM for Diversification, Return Potential
The research suggests that client resistance is largely a thing of the past. Just 19% of advisors said the majority of their clients resist the importance of emerging markets’ exposure to the long-term growth of their portfolios.
More than half (56%) of surveyed advisors say their clients understand portfolio diversification to be the main objective of emerging market equity. One-quarter of advisors say their clients invest in EM for the potential for above-average returns. The potential to benefit from global themes is reported as a main EM objective by just 16% of advisors. (For help in educating clients on global themes shaping the growth of emerging markets, subscribe to Calamos’ weekly EM Snapshot).
EM Investing Requires Active Management
The impact of emerging markets—as infrastructure is built, corporations mature and a consumer class emerges—is being felt across the world, across countries and across companies. These opportunities are dynamic. They present themselves in windows that continuously open and close. How could a fixed basket of emerging markets countries-only ever keep up?
What’s more, having the flexibility to invest in developed market-domiciled companies that generate a significant portion of revenue or invested capital in emerging markets widens the investable opportunity set. This broader approach to “emerging markets” growth more accurately reflects global business dynamics, enables selection from more attractive business models and offers the potential to exploit relative opportunities in stock prices and valuations.
In fact, two-thirds of advisors say they prefer active management for emerging markets investing.
The survey revealed that the majority of advisors allocate to more than one manager, whether for diversification or to blend different styles. As allocations grow, we’d expect this trend to become even more pronounced.
Crises Are To Be Expected—And Avoided
Emerging markets investors need to accept that there will be crises, as predictably as every 12-18 months. In order to keep clients invested and moving forward, crises leading to large portfolio drawdowns need to be avoided—which also bolsters the case for active management.
The survey suggests that advisors do a good job of educating their clients about market volatility. Four out of 10 advisors say volatility doesn’t factor into client conversations. Some say their clients have used volatility as an occasion to discuss adding to allocations.
But unfortunately, volatility can seriously undermine clients’ resolve. Thirty-one percent of those surveyed report that volatility has the potential to rattle even clients with the best of intentions.
Further, volatility is the dominant concern among clients who resist exposure to emerging market equity, hinting at the challenge faced by advisors nonetheless confident of their clients’ need for an EM allocation.
Evaluating EM Options
The use of emerging markets in the construction of a client portfolio is one of the more obvious ways in which an advisor provides and demonstrates his or her value.
With the growth of the emerging markets category comes more choice. Here are some recommendations we make to advisors evaluating their EM options:
- The evolution of EM investing has had the effect of reducing volatility. Unlike 20 years ago, EM investing today includes both investing directly in developing countries and in companies that derive revenue from a growing EM middle class. The combination can lead to a lower-volatility means of accessing emerging markets growth—which can keep clients invested.
- EM companies themselves are becoming more developed and sophisticated, expanding their capital structure beyond only equity and into fixed income and convertible securities. This provides more options for investors to access the EM markets while investing in typically less risky securities. The result: A more diversified portfolio with an improved risk/reward profile.
- Funds that are geographically flexible and that can invest across the capital structure often expose investors to less risk while also providing investors access to the potentially greater gains available from the emerging markets.
- Understand what’s driving EM returns, and the risk implications:
- Is it market capitalization? Many funds move from small to mid to large caps and back.
- What are the exposures—is the fund concentrated in countries, sectors, market caps? It’s not unheard of for a fund to invest more than 50% of its net assets in three countries.
- Are EM returns being driven by investing outside of EM into frontier markets?
- Is it currency hedging? Hedging can be a zero sum game over the long term and typically takes a currency expert to generate alpha. It is also expensive and illiquid to hedge in EM currencies.
Participating on the upside, avoiding crises, minimizing volatility and drawdowns—all are important in EM investing, to assure that clients stay fully invested to maximize returns. It’s well documented that investors underperform because of their propensity to sell at lows and buy at highs. This is the added benefit of diversification, which is the ultimate driver of performance. Adding a risk managed approach to EM investing makes the portfolio that much stronger—and the client likelier to achieve his or her desired investment outcome.