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Strategy for Emerging Markets Investing

Investing in a Volatile Asset Class

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In a world of low yields and slug­gish growth in most of the devel­oped world, many con­sid­er emerg­ing mar­kets invest­ing an out­let for those seek­ing growth of assets. How­ev­er, it is also wide­ly known that invest­ing in emerg­ing mar­kets is a ven­ture fraught with risks.

Stan­dard finan­cial the­o­ry states that the high­er the risk, the high­er the reward. An investor will­ing to take on volatil­i­ty or the poten­tial for loss­es should be com­pen­sat­ed for accept­ing that risk. Per­haps no asset class exem­pli­fies this trade-off more than emerg­ing mar­kets. Since MSCI start­ed track­ing emerg­ing mar­kets in 1988, the asset class has clear­ly had high­est returns and biggest risks of any of the major asset class­es.

Return-Standard Deviation - Emerging Markets vs Other Asset Classes

Why Invest in Emerging Markets?

The advan­tages of emerg­ing mar­kets are well known. Fre­quent­ly cit­ed are such strengths as:

  • High­er upside poten­tial
  • Demo­graph­ic trends favor­ing emerg­ing mar­kets over many devel­oped coun­tries
  • Bour­geon­ing mid­dle class and con­sumerism in emerg­ing mar­kets
  • Grow­ing share of glob­al GDP
  • Wealth of com­modi­ties and resources in emerg­ing mar­kets
  • Diver­si­fi­ca­tion ben­e­fits to tra­di­tion­al port­fo­lios

Very few peo­ple argue again­st the upside poten­tial of emerg­ing mar­kets. And yet in spite of the­se advan­tages many investors tend to shy away from emerg­ing mar­kets. Over­all, emerg­ing rep­re­sents only 3% of U.S. mutu­al fund assets (accord­ing to a recent Calam­os study). For many investors, the risks of emerg­ing mar­kets out­weigh the rewards.

And no doubt about it, the risks are real. Polit­i­cal risk, eco­nom­ic risk, cur­ren­cy risk, and mar­ket risk are all present in emerg­ing mar­kets. The­se risks occa­sion­al­ly man­i­fest them­selves in high­er volatil­i­ty and large sell-offs.

The chart below illus­trates both the highs and lows of invest­ing in emerg­ing mar­kets in the form of rolling, one-year returns.

Return over Time - Emerging Markets vs S&P 500

Emerging Markets Investor Conundrum:

How does one max­i­mize the poten­tial of emerg­ing mar­kets, while min­i­miz­ing the risks?

Given the dim out­look for a tra­di­tion­al 60/40 bal­anced port­fo­lio, emerg­ing mar­kets are one of the few assets with the upside poten­tial to meet the return needs of an investor.

Swan believes it has a unique solu­tion that can max­i­mize return and min­i­mize risk of emerg­ing mar­kets. It is the same strat­e­gy that has been suc­cess­ful­ly applied to U.S. Large Cap equi­ties for over 18 years; the Defined Risk Strat­e­gy (DRS). The DRS was built around the idea that the biggest risk to an investor’s wealth is the large scale, sys­tem­at­ic sell-offs that occa­sion­al­ly befell the mar­kets.

The DRS direct­ly hedges again­st bear mar­kets via long-term put options. Not only are the put options designed to pro­tect dur­ing a bear mar­ket, the puts are also designed to be a source of cap­i­tal for re-invest­ing into the mar­kets when the mar­kets are trad­ing at a dis­count after a large bear mar­ket sell-off.

By re-hedg­ing and re-invest­ing after a bear mar­ket sell-off, Swan believes the DRS is supe­ri­or to mar­ket tim­ing. One of Swan’s core beliefs is that it is dif­fi­cult, if not impos­si­ble to call the tops and bot­toms of mar­kets and to build a suc­cess­ful long-term strat­e­gy by tim­ing the mar­kets. This truth is espe­cial­ly rel­e­vant in emerg­ing mar­kets. As seen in the pre­vi­ous graph, emerg­ing mar­kets are not­ed not only for their steep decli­nes but also for their very sharp ral­lies. In oth­er words, if your tim­ing is slight­ly off and you miss the ral­ly, you miss big.

Below is a table show­ing the returns of emerg­ing mar­kets com­ing off the bot­tom. The first two columns spec­i­fy a mar­ket sell off and the date of when the ral­ly start­ed. The mid­dle column shows the 12-mon­th return if some­one had per­fect fore­sight and bought at the bot­tom of the mar­ket. The fourth column is the impact of miss­ing the first mon­th of the ral­ly and the final column shows the 12-mon­th returns if the first three months of the ral­ly are missed.

Returns if You Missed Rally after Major Market Event

Conclusion

We believe the above infor­ma­tion sim­ply rein­forces the impor­tance of Swan’s mot­to: “Always Invest­ed, Always Hedged.”

We also believe that our approach to man­ag­ing risk in emerg­ing mar­kets is com­plete­ly unique. By hedg­ing again­st bear mar­kets and seek­ing to gen­er­ate cash flow through option pre­mi­um, we believe we have fun­da­men­tal­ly changed the risk/return pro­file of emerg­ing mar­kets.

 

Click to find out more about the Defined Risk Strat­e­gy applied to Emerg­ing Mar­kets, or call 970.382.8901.

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsAbout the author: Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.

 

Impor­tant Notes and Dis­clo­sures:

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®). All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com. 048-SGI-022416