A 5-point checklist for emerging markets investing

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Research and experience by Parametric, the US implementation manager, has thrown up a five-point checklist for emerging markets investors, blending the benefits of active and passive styles. Some active protection strategies, such as currency hedging, are just not worth chasing.

According to Raewyn Williams, Parametric Australia’s managing director, research, super funds need to keep the best and avoid the worst of active and passive emerging market investment strategies, and the checklist, based on a number of the firm’s published research papers, should help funds achieve this goal.

“At a time when some super funds are increasing their weight to emerging market equities in a search for higher returns, what makes a good emerging market investment strategy is a question well worth asking,” she said last week.

“Many emerging market fund managers are capacity-constrained, so as super funds look for new managers and strategies it’s worthwhile revisiting what makes for an effective exposure to these equity markets.”

The five-point checklist is:

  1. Avoid under-diversifying – Diversification is a rare “free lunch” for portfolios, but a typical passive emerging market portfolio (and many active portfolios) is not well diversified and can have high concentration risks;
  2. Prioritise country selection – The only broad risk that is really important to manage in emerging market portfolios is country selection; other risks matter less so managing them is second order. This is very different to the risks that drive developed market equity returns.  The best “bang for your buck” fee spend in emerging markets is a strategy that prioritises country selection;
  3. Stay unhedged – Currency hedging is not worth the effort – for philosophical and practical reasons.  It can actually undermine what super funds are trying to achieve in emerging markets;
  4. Focus on implementation – Emerging markets attract high transaction costs and super funds must look for fund managers who measure and manage these costs.  High turnover emerging market strategies have a real headwind versus low turnover strategies because of these transaction costs; and
  5. Favour transparency – Emerging markets are, by definition, a high-risk asset class and can deliver shocks, so super funds need transparency about what’s happening inside their emerging market portfolios.  This again creates a headwind for active emerging market strategies that can be opaque “black boxes” versus simpler, rules-based emerging market strategies.
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