Combining Emerging Markets Equities with Bonds Exposure
by Patrick Oberhaensli, on Aug 21, 2019 2:15:00 PM
Numerous institutional investors from developed countries tried more than a decade ago to diversify further their multi-asset portfolio by including (global) emerging markets equities. It seemed logical to “complete” the exposure to developed equities with emerging markets stocks, but in reality, it didn't work out as expected. This led to the idea to include emerging markets bonds as well, that again seemingly made sense in order to further balance the opportunities. Does it function well? Or are there better solutions for the combination with bonds? These are the questions we will address in this article.
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To be precise, when we talk about emerging markets bonds, we mean investments in sovereign bonds and not corporate bonds. The latter is also a defined market but actually not the universe we will be covering here.
Currently, roughly half of the emerging markets bonds are non-investment grade. This is in the context of recent global growth with 2017 exposing a growth rate that had not been seen since a number of years. It therefore cannot compare with the (near) top-quality government bond issues of the US and in particular Germany (or in terms of regions the European Union). In others words, in case of a large market crisis, the situation can deteriorate quite quickly when it comes to an emerging markets bonds investment.
Combinations Within Emerging Markets
Combining global emerging markets equities and bonds with varying weights, we get following: For the period starting in January 2008 up to the 19th of July 2019, including specific costs
The 50% emerging markets equities and 50% bonds case - In form of a constant mix:
The 30% emerging markets equities and 70% bonds case:
The 20% emerging markets equities and 80% bonds case:
We can see that adding emerging markets bonds to the portfolio actually doesn’t help in a period that also covers a very sharp market drawdown for both emerging markets equities and bonds. The reason is found in the similar timing of the maximum drawdowns: a characteristic one wants to avoid when combining different markets.
There was no such thing as a “flight to quality” that could be observed for the heterogeneous and lower quality emerging markets bonds. In reality, it was (market) contagion that occurred, and almost exactly at the worst point in time. This leads us to consider US Government bonds that have the necessary quality and for which very long durations are readily available.
Does an Emerging Market Investment pay off in the long run?
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The Smart Combination of Emerging Markets Equities and Top-Quality Bonds
Combining global emerging markets equities and US Government bonds with very long duration with varying weights, resulted in the following: For the period starting in January 2008 up to the 19th of July 2019, including specific costs
The 50% emerging markets equities and 50% US Government bonds case:
The 30% emerging markets equities and 70% US Government bonds case:
The table with the 50%/50% allocations shows that taking US Government bonds, instead of emerging markets (Sovereign) bonds, leads to a strong improvement of the portfolio characteristics. This is seen especially with the maximum drawdown that is now reduced by almost 14% points - the exception is the months with positive returns that are basically the same in both cases.
By increasing further the allocation of bonds to 70%, we can clearly see that the diversification effect allows to achieve results that meet the expectations at all levels: the US Government bonds portfolio’s yearly volatility of 13.86%, maximum drawdown of 26.59% and Sharpe Ratio of 0.35 are all well beaten despite its Compounded Annual Return of 6.30% that is only a bit higher (by 10 basis points).
The key take-away from our analysis is that should the investor adopt a dedicated long strategy for his/her emerging markets equities strategy, then combining it with bonds is essential (in addition to rebalancing) in order to obtain a useful risk-adjusted return.
The diversification wouldn't come from including emerging markets bonds as they are simply too risky but from US Government bonds in particular. The results, with the appropriate weightings (in favor) of bonds, are then pretty relevant.
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