Global risk appetite returned with full force this week, with emerging market assets in particular benefitting from the reversal in sentiment. One of the more surprising results was the identity of this year’s top performer to date: Egypt, a country still in the grip of political and economic upheaval, has delivered storming returns on equities.
But Egypt’s stock market performance is just a sign of how correlated markets are - it’s rising along with everything else. And while that may have been welcomed by anyone who understood that getting on board the riskiest markets was the way to ride the rally, tight correlations between markets is a problem for many investment strategies – notably any that aim to reduce risk through diversified portfolios. After all, the value of diversification can be seen as rather limited when a theoretically optimised international portfolio ends up gyrating in line with a far cheaper S&P500 tracker.
The correlation between moves in the major emerging market regional equity benchmarks – which reflect what the majority of international investors will be exposed to – has been rising steadily over the past decade and is currently extremely strong. This is a significant blow for the argument that investing in emerging markets works because they add valuable diversification.
In theory, it’s possible to get far greater diversification through investing widely around the world – but to get to the lowest correlation markets, you need to go far out on the frontier. This is one of the reasons frontier investing is becoming increasingly popular, along with the promise of faster growth, lower valuations and more excitement. While frontier investment is not yet mainstream, the launch of products such as db x-trackers MSCI Bangladesh and MSCI Pakistan ETFs towards the end of last year are a move in that direction.
But is it sensible to invest in frontier markets solely to end up with a less correlated portfolio? Almost certainly not. The greater correlation between mainstream emerging markets and developed markets does not necessarily reduce the ability of emerging markets to outpeform in the mid-to-long-term.
This is a nuance missed by some investors. In a similar way to how FX volatility in 2011 has led to increased talk of whether it’s best to hedge FX exposure when investing in EM equities (Answer: Probably not), it’s easy to lose sight of the longer-term objectives of investing in emerging markets and end up reacting to short-term trends and volatility.
If – as some suggest – asset correlations are now expected to ease, this may become less of a preoccupation. But if they don’t, investors should probably be careful about being drawn into frontier investing for the wrong reasons. There are sound arguments in favour of investing in some of these markets, but accepting greatly increased political, economic and market risk in return for an apparent diversification that is likely to vanish as more investors pile into these small, illiquid markets is not one of them.
Eksewhere on the site, we also noted that flows into emerging market debt also remain strong - and in particular, we looked at Venezuela, a recent star performer, as investors start to hope that Hugo Chavez could soon be out of office.
We also looked at China’s latest cut in the bank reserve requirement ratio – not so much a loosening as a tweaking, reckon some analysts – rising inequality in India and a preview of the forthcoming G20 meeting this weekend.