The Case for Managed Volatility in Emerging Markets. Investment Focus

Transcription

1 Investment Focus The Case for Managed Volatility in Emerging Markets While emerging markets equities have gained significant interest from global investors over the last several years, the asset class s volatility remains an ongoing concern. In our view, a low-volatility equity portfolio can produce a stable pattern of returns in emerging markets stocks, potentially leading to more favorable risk-adjusted results. In addition, low-volatility allocations in emerging markets generally result in a more diversified group of stocks relative to market capitalization-weighted benchmarks.

2 2 The use of an emerging markets low-volatility equity strategy as part of an emerging markets allocation offers a number of significant advantages. Low volatility and emerging-market equities are terms that are rarely found in the same sentence. Investors generally accept that investing in emerging markets will involve a bumpy ride in order to realize attractive long-term returns. We believe the opportunity to participate in the fastest growing areas of the global economy is compelling and a reason behind the heightened interest in the asset class. At the same time, one s entry and exit point can have a decided impact on the overall investment experience. The fear of buying too high and selling too low is certainly a larger concern in such a volatile asset class. A low-volatility portfolio of emerging-market equity investments may produce a smoother return pattern when contrasted with a marketweighted benchmark or even with style-specific approaches. This can serve to mitigate the point-of-entry risk and possibly allow for an increased allocation to emerging markets without changing aggregate portfolio risk. In addition, a low-volatility allocation in emerging markets may result in more diversified economic exposures, whereas a capitalization-weighted benchmark tends to concentrate weighting in sectors and stocks that are currently in vogue. This paper explores these issues in greater detail. The broad benefits of a smoother pattern of returns provided by low-volatility stocks are well-documented for developed markets and, in our previous paper The Low-Volatility Equity Opportunity, we provided an analysis of the key aspects of lowvolatility investing. Does Low-Volatility Investing Work in Emerging Markets? Exhibit 1 illustrates that investing in emerging-market equities has rewarded investors with outsized returns for most of the past decade and a half, especially in comparison to investing in developed markets. On the other hand, the steep declines in 28 and latter half of 21 were especially jarring and likely created anxiety for investors. Emerging markets equities have been, and are likely to continue to be, a volatile equity asset class. The relative immaturity of the markets, lack of standardized financial reporting and strict corporate governance principles, as well as numerous geopolitical influences, are likely to maintain the higher level of volatility for emerging markets investors. Exhibit 1 Returns and Volatility for Emerging- and Developed-Market Indices Growth of $ Rolling 36-Month Standard Deviation (%) MSCI Emerging Markets Index MSCI EAFE Index MSCI World Index S&P 5 Index As of 3 June 213 Source: MSCI, Lazard

3 3 Exhibit 2 Returns for High- and Low-Volatility Stocks in Emerging Markets Growth of $ As of 3 June 213 Data are based on a universe of emerging markets stocks (currently 1,9) with market capitalization above $2 million. Source: MSCI, Standard & Poor s, Citigroup, Lazard Long-term investors have been rewarded with additional return by assuming the risks of emerging-market investing. Therefore it would seem to follow that investing in higher risk emerging-market stocks would lead to outsized returns especially compared to lower risk stocks. To test this hypothesis we looked at the return differences between high- and low-volatility stocks through time, with the results shown in Exhibit 2. Volatility was calculated as standard deviation in daily prices over the previous 12 months. Linking a monthly set of returns for the most volatile and least volatile quintiles of stocks (equally weighted) from 2 (the inception of the revised MSCI Emerging Markets Index) showed a significant premium from investing in low-volatility stocks. While turnover and transaction costs are not reflected in either computation, we believe it is clear that there is a significant performance advantage in favor of low-volatility stocks in the emerging markets universe. Critics may point out that this study was largely influenced by the TMT bubble in This appeared to be a perfect period for such an approach, as the high volatility sectors of the market virtually collapsed with losses exceeding nearly 5% in value. To be sure, most of the relative advantage was gained during this three-year period. By narrowing the study to exclude this period, we still observe that the low-volatility stocks modestly outpaced high-volatility stocks with a noticeably smoother path of returns (see Exhibit 3). Regardless of the period, the reduction in risk was constant, varying from 1% to as much as 5% over any rolling three-year period (see Exhibit 4). This lower volatility has translated into more favorable risk-adjusted returns over time, as illustrated by the Sharpe ratio (see Exhibit 5). The low-volatility stocks certainly held their own through the less volatile and strong performance period of and defended extremely well in 28. Much of the return premium was sacrificed in the rally only to be regained in the 211 decline. Exhibit 3 Returns for High- and Low-Volatility Stocks in Emerging Markets, excluding the TMT Bubble Growth of $ Exhibit 4 Volatility for High- and Low-Volatility Stocks in Emerging Markets, excluding the TMT Bubble Rolling 36-Month Standard Deviation (%) Exhibit 5 Risk-Adjusted Returns for High- and Low-Volatility Stocks in Emerging Markets, excluding the TMT Bubble Sharpe Ratio As of 3 June 213 Data are based on a universe of emerging markets stocks (currently 1,9) with market capitalization above $2 million. Source: MSCI, Standard & Poor s, Citigroup, Lazard

4 4 The Problem of Capitalization Weighting in Emerging Markets Market capitalization-weighted benchmarks can often lead to unwanted portfolio concentrations as investors bid up favored companies, sectors, or areas to outsized levels. The composition of the emerging markets may also lend themselves to a more volatile return pattern with the benchmark s higher allocation to financials, materials, utility, and energy stocks. With over half of the benchmark concentrated in these four sectors based on allocations as of June 213, benchmark-driven investors can be especially susceptible to commodity prices and the future direction of interest rates. Exhibit 6 further illustrates the overweight sectors, where we contrast the MSCI Emerging Markets Index with global stocks (represented by the MSCI World Index) and with an emerging markets low-volatility portfolio (represented by the Lazard Quantitative Equity [LQE] Emerging Markets Managed Volatility strategy). Exhibit 6 Examining Sector Weights in Emerging Markets (%) MSCI World Index MSCI Emerging Markets Index Difference Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecom Services Utilities LQE Emerging Markets Managed Volatility MSCI Emerging Markets Index Difference Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecom Services Utilities As of 3 June 213 The allocations mentioned are based upon a portfolio that represents the proposed investment for a fully discretionary account. Allocations are subject to change. All data reflect rounding. Source: MSCI, Lazard Exhibit 7 A Low-Volatility Portfolio Can Offer Greater Sector Diversification in Emerging Markets MSCI Emerging Markets Index Sector Weights (%) LQE Emerging Markets Managed Volatility Sector Weights (%) Utilities Telecom Services Materials Information Technology Industrials Health Care Financials Energy Consumer Staples Consumer Discretionary As of 3 June 213 The allocations mentioned are based upon a portfolio that represents the proposed investment for a fully discretionary account. Allocations are subject to change. The data presented above represents combined results of information derived from the LQE Emerging Markets Managed Volatility Simulation, which incorporates data from June 25 through September 211 and, thereafter, the actual performance of the LQE Emerging Markets Managed Volatility composite. This information is for illustrative and comparative purposes only and is supplemental to the complete composite performance. Please refer to the Simulated Performance Information Disclosure Notes for the complete disclosure notes and simulated performance information, and to the Important Information section for a brief description of this composite. Source: MSCI, Lazard Emerging markets have had a long history of repeated speculative bubbles which typically correct themselves in a sudden and painful manner, often to the investor s dismay, in our view. Country and industry concentrations have routinely dominated the capitalizationweighted benchmarks through time and corrections can be both significant and painful. For example the collapse in commodity prices has reduced the market index weight in materials by over 3% in just the past 12 months. This same concentration also applies at the security level where today nearly 2% of the index is weighted in the largest ten companies, out of a universe of over 8 stocks. A low-volatility portfolio tends to maintain exposure to sectors that is typically more stable and evenly distributed than the capitalizationweighted benchmark, as shown in Exhibit 7. By maintaining a more

5 5 consistently diversified exposure to sectors, we believe an investor in a low-volatility portfolio is less susceptible to such speculative excesses that can dominate a capitalization-weighted benchmark. Trading off systematic risks (interest rates, commodity prices) for stock specificrisk is likely to reduce overall risk while still allowing for the desired growth from emerging-market investing. In our view it is also worth noting that one of the compelling reasons for investing in emerging markets is a desire to benefit from the growth of the middle class consumer. With consistently greater exposure to the telecom services, consumer staples, and consumer discretionary sectors, a low-volatility portfolio is more directly tied to this growth and less to the global influences present in, for example, materials and energy stocks. Exhibit 8 Performance Characteristics of Emerging Markets Equity Managers, for Five Years Ended December 212 Annualized Return (%) LQE Emerging Markets Managed Volatility Median Return MSCI Emerging Markets Index Median Volatility MSCI Emerging Markets Value Index MSCI Emerging Markets Growth Index Annualized Volatility (%) As of 31 December 212 Data are based on the Mercer emerging equity universe and this universe has been modified by including the Lazard strategy shown on this chart. The data presented above represents combined results of information derived from the LQE Emerging Markets Managed Volatility Simulation, which incorporates data from June 25 through September 211 and, thereafter, the actual performance of the LQE Emerging Markets Managed Volatility composite. This information is for illustrative and comparative purposes only and is supplemental to the complete composite performance. Please refer to the Simulated Performance Information Disclosure Notes for the complete disclosure notes and simulated performance information, and to the Important Information section for a brief description of this composite. Past performance is not a reliable indicator of future results. Monthly data. Reporting currency: USD unhedged. Source: Lazard, Mercer, MSCI Portfolio Implications The use of an emerging markets low-volatility equity strategy as part of an emerging markets allocation offers a number of significant advantages. In Exhibit 8 we use the LQE Emerging Markets Managed Volatility strategy as an illustrative example to highlight some of these favorable characteristics. The pattern of returns is differentiated from most emerging-market equity managers. Without sacrificing longterm returns from the asset class, the strategy offers lower volatility and low correlation to most emerging-market equity approaches. The return pattern occupies a distinct point in the emerging-market equity universe and is not easily duplicated by defensive or value-oriented managers, as shown in Exhibit 8. For investors who are risk budgeting, an allocation to such a strategy either permits an increase to emerging markets and/or reduces total portfolio risk without impacting longterm return expectations. Equally important, it helps to mitigate point-of-entry risk into emerging markets. It can be difficult to commit to an asset class that has experienced such an extraordinary run. Low-volatility strategies are designed to mitigate losses in difficult market periods, partially insulating the investor from a poor entry point. At the same time, the strategy is designed to participate in a significant majority of the upside gains in the event of a sharp rally. Conclusion Low volatility and emerging markets are not mutually exclusive terms. The low-volatility effect (i.e., the ability to generate market returns with a 2% 3% reduction in standard deviation) has already been well-documented in developed markets. Our research supports the application of such an approach to emerging markets for many of the same behavioral and arithmetic reasons. In emerging markets, a lowvolatility equity portfolio offers the potential to: Lower emerging-market equity risk Diversify holdings from a market capitalization-weighted benchmark Avoid market concentration risk Complement most emerging-market equity strategies with low correlation of returns Increase allocation to emerging markets without increasing aggregate portfolio risk We believe the benefits of a low-volatility equity strategy argue for a meaningful commitment to low-volatility portfolios for any emergingmarket equity investor.

6 6 Simulated Performance Information Disclosure Notes Performance returns for the LQE Emerging Markets Managed Volatility strategy from October 211 to the present day are based on live accounts and represent GIPS compliant returns. The performance presented in this report from June 25 to September 211 is for the LQE Emerging Markets Managed Volatility strategy and is hypothetical performance for the period when the product was not yet offered by Lazard Asset Management (the Simulated Model ). Performance for the Simulated Model is presented gross of fees. It is shown for illustrative and comparative purposes only. The Simulated Model s returns were constructed by utilizing LQE s global stock selection model to select stocks within the Emerging Markets. The stocks were screened for data availability and liquidity requirements and only those equity securities that satisfied these data and liquidity requirements were included. The portfolio s construction methodology unique to the Simulated Model includes limiting exposure to any one sector group to 2% of the total portfolio as well as a 1.5% maximum allocation to any one stock. The Simulated Model also incorporates a comprehensive and proprietary risk model that ensures market capitalization distribution and industry diversification. Additionally, the risk model employs measures to monitor and control long-term portfolio risk characteristics. Lazard Asset Management did not manage the Simulated Model during the periods shown. The hypothetical performance presented herein includes historical financial data to show what decisions would have been made if the strategy were employed. Simulated performance results are shown for illustrative purposes only and do not represent actual trading or the impact of material economic factors on Lazard Asset Management s decision-making process for an actual Lazard Asset Management client account. Simulated performance results were achieved by means of a retroactive application of a model designed with the benefit of hindsight. Returns are presented gross of estimated fees. Performance for all periods reflects transaction costs, dividends reinvested and income received from the underlying securities. The returns are time-weighted, are based upon monthly portfolio valuations, and include the reinvestment of all earnings as of the payment date. Returns are shown before custody fees. The performance of the Simulated Model represents past performance and is not a reliable indicator of future results. Important Information Originally published on 3 July 213. Revised and republished on 25 June 214. Lazard Asset Management LLC is a US registered investment advisor and claims compliance with the Global Investment Performance Standards (GIPS ). To receive a complete list and description of Lazard Asset Management s composites and/or a presentation that adheres to the GIPS standards, please contact Henry F. Detering, CFA at Lazard Asset Management, 3 Rockefeller Plaza, New York, New York or by at Henry.Detering@Lazard.com. Provided below is a description of the composite, the performance of which appears on the preceding pages. The Lazard Quantitative Equity Emerging Markets Managed Volatility strategy is a broadly diversified international equity strategy that seeks to outperform the MSCI Emerging Markets Index by 2% per annum with 2% 3% lower volatility (standard deviation of returns) than the benchmark. Stocks are selected for the strategy using a proprietary, quantitatively based investment process that evaluates each stock relative to its emerging-market competitors and where the stock can potentially deliver lower risk than the benchmark. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the date of this presentation and are subject to change. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Emerging-market securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging-market countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in emerging-market countries. Certain information included herein is derived by Lazard in part from an MSCI index or indices (the Index Data ). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom. The MSCI Index Data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Past performance is not a reliable indicator of future results. 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