AllianceBernstein's Morgan Harting explains why the traditional all-equity approach to investment in this area is not the best approach.
The share of the world’s gross domestic product generated by emerging and developing countries is likely to overtake that of “advanced” countries by 2013.
Capturing a share of that growth is going to be vitally important for the well-being of investors in less dynamic economies. Tapping the markets of the 67 emerging countries could also add to the diversification of their portfolios.
Unfortunately for UK institutions, the rosy prospects for EMs have largely been priced into many individual stock and bond valuations at a time when institutions are often heavily underweight. Is it too late for them to climb aboard?
Their reluctance is understandable, given EMs have proved risky in the past. Indeed, EM equity volatility remains higher than developed. And rising inflation could be a threat to the EM growth and currency appreciation story. But we would argue the traditional all-equity approach to investment in this area is not best designed to minimise unwanted surprises.
Adding debt can help dampen the volatility of an equity portfolio and provide some protection. And the relatively high return potential of EM debt means that it can bring diversification to equity portfolios without sacrificing much return.
Such an all-embracing approach also offers scope for active allocation between asset classes, often the single biggest influence on performance. Investors should not expect a repeat of the large gains from active asset allocation seen in the past, but an intelligent approach to managing assets and capital structures can still be highly effective.
Take, for example, an attractive issuer of both debt and equity, like Russia’s Gazprom. The best returns here are likely to come by concentrating only on the equity, where the downside risk also appears to be contained by its low valuation.
However, a two-pronged approach may work better at Commercial Bank of Qatar. In this case, the high dividend yield on the equity can be used to cover the cost of purchasing insurance in the credit markets against extreme events.
Currency provides another source of return. In Chile, upside for the country’s stocks and government bonds looks limited, given widespread support for its economic policies. But that background makes the currency more promising, with interest rates being raised to stem inflation pressures and the peso appreciating on the back of strong capital inflows. So we would buy the currency – not the stocks or bonds.
While no investor can afford to ignore EMs these days, they need to adopt an all-encompassing approach. Having access to a broader range of countries and asset classes gives them more ways to win.
Morgan Harting is senior portfolio manager at AllianceBernstein
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