Emerging Market Portfolio Strategies, Investment Performance, Transaction Cost and Liquidity Risk

Abstract

Emerging equity and fixed income markets (EM) have generally been open to foreign investors for more than two decades now, and much has been learned about their risk-and-return properties during that time. As EM are now more investable than ever, increased integration may have reduced opportunities for investors searching for higher yields, as they look for high expected returns from assets that can be purchased at prices cheaper than comparable assets in developed countries. Today, the question is whether the empirical evidence would still suggest that there is a significant benefit to including EM assets in a globally diversified portfolio. Also, taking into consideration all the relevant risk characteristics, do emerging markets have more downside risk than developed markets. The goal of this paper was to explore the prominent risk drivers in the EM space, as we showed significant continuity and variation vis-a-vis developed markets with conditions changing across different markets, countries, sectors and over time. We argued the case for EM as a relevant asset class overall. We found that country factors still dominate cross-country valuations; investment barriers and other country factors are priced in, but ‘risk appetite’ factors are important as well. High country-specific volatility can be diversified away, and a diversified basket of EM is not necessarily riskier than a DM one and the high individual country volatility and country factors create potentially useful investment opportunities for active asset managers. All in all, EM assets still have higher risk than most developed markets (DM) and, as a result, continue to command higher expected returns. As factor investing has become increasingly popular in DM, we show that risk factor-based investment strategies have historically worked in EM too. While we focus most of our discussion on equities, other asset classes have gained more prominence over time, such as corporate bond market and frontier emerging markets. Since these latter markets are currently less well-integrated within the global economy, investors having exposure to these markets can cushion themselves against extreme movements in their portfolio returns. Institutional investors still appeared to be underweight in EM and there is considerable dispersion across different institutions. Investors’ overall preference tends to favour broad-based exposure to EM, i.e. not limiting themselves to a specific subset of investment opportunities. In addition, EM assets are increasingly being viewed as an integrated part of global equity allocation. Lower transaction costs and increasing market liquidity have played an important role in fostering the expansion of the investor base in EM, however, transaction data – such as bid-ask spreads or market impact estimates – and estimated liquidity measure continue to show a wide gap vis-a-vis DM. Moreover, when liquidity is priced in, local risk factors matter even under the hypothesis of global market integration; according to academic evidence, systematic liquidity risk appears to be important empirically, much more so than local market risk. The implications of the higher trading costs and lower liquidity of EM has fostered the role of benchmark index replication ('passive’ investment), boosting the expansion of efficient tools for index tracking, such as Exchange-Traded Funds (ETFs). Index funds and ETFs allow investors to buy and sell less liquid assets indirectly for low transaction costs and their management fees are typically very low. Index funds and ETFs enable short-term investors to invest indirectly in illiquid stocks at low cost. Therefore, investors’ compensation for investing in EM illiquid stocks has been eroded over the years as index funds and ETFs have become more popular. These tools have contributed to a decline in the liquidity premium. All in all, according to the empirical evidence discussed in this paper, it appears that liquidity premia are not likely to be a prominent performance driver nor a source of significant systematic risk for well diversified EM portfolios.