Emerging Markets: Building An Investment Case

By M. Isi Eromosele

Since the systematic risk in each country is the dominant factor in explaining returns, selecting and weighting countries is the most determinant of investment success in any diversified emerging market strategy.

While emerging countries may be quite risky on an individual basis, combining them in an equally weighted portfolio can significantly reduce the risk through the power of diversification that their low correlations provide.

Additionally, a broadly diversified approach that highlights the smaller of the emerging markets is an even more powerful return enhancer and risk reducer. One would need to think about the performance history of an equal weighted country approach comparative to a cap-weighted approach.

The investment case for highlighting smaller markets is strong (low valuations, higher growth rates, low correlations). An analysis of returns by market capitalization size reveals a powerful historical relationship between market size and performance.

This inverse market size effect is one primary driver for the excess performance of equal weighting vs. cap weighting countries. A more detailed look at the smallest of the emerging markets, sometimes called the frontier markets, strengthen the case for emphasizing smaller markets.

A moderate investment in these markets can offer the most compelling combination of growth and correlation (both cross correlation and correlation within the global market) because frontier markets in all regions - Africa, Middle East, Eastern Europe, Asia and Latin America - have projected earnings growth rates that are among the fastest in the world.

Indeed, both the reality and perception of risk in these countries are high. However, the influence of macro-economic improvements and effects of globalization are also high. Adequately structured long term, diversified allocated investments in these markets offer a solid portfolio packaged risks but good return benefits.

The performance benefits from disciplined rebalancing are evident as a direct consequence of high volatility and low correlations - two factors that are prominent in emerging markets. A structured approach that involves rebalancing to fixed weights can turn volatility into an asset in the chase for superior risk adjusted returns.

This is driven by the interface of volatility and correlation. The greater the volatility, the larger the dispersion between overperformers and underperformers, resulting in higher profits that is derived from timely rebalancing. The lower the correlation among assets, the more opportunities there are for rebalancing from an asset that has appreciated to one that has depreciated. Emerging markets, with both of these qualities, are magnificent candidates for securing this rebalancing premium.

It is undeniable that the economies of the world have become more linked and interdependent as sales and distribution channels have intensified in sophistication and accessibility.

These trends have resulted in security returns that are also linked and now move more in tandem with each other than was previously was the case. Correlations of emerging countries have increased, especially among the larger and middle-sized segments.

The smallest of the emerging market countries continue to show a relatively stable and persistently low level of correlation as their economies still remain somewhat independent of the world stage.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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