Emerging Markets & The Remarkable Short Market Contribution
by Patrick Oberhaensli, on Aug 28, 2019 11:10:00 AM
Is it possible to sharply improve the risk-adjusted performance of global emerging markets equities using short-exposures? The answer is yes, by using short futures positioning at the level of the whole market. Not only is it much easier than with individual stocks, but it is also a very regulated market with, among others, no idiosyncratic risks. There are different ways to benefit from the characteristic drawdowns of the aggregated (emerging markets equities) market. In this article, we will explore these benefits in the context of a particular case study.
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Market Behavior Observations
A first observation comes from the massive drawdown during the 2008 great financial markets crisis, in which both global emerging markets equities and US large cap equities had their worst sell-off in recent years:
That synchronal sharp price down movement is not a surprise and indicates that there is unlikely a decorrelation between the two markets when the investor needs it most. If one can extract value from a correct short positioning in US large cap equities during crashes, then it is likely helpful for emerging markets equities as well.
The key observation regarding the “flight to quality” phenomenon during times of strong equity market stress can help fill that value extraction. Given that emerging markets bonds are similarly affected, one can develop an out-of-market positioning. This observation is discussed further, in the context of asset allocation (not short or out-of-the-market positioning) in our article “Combining Emerging Markets Equities With Bonds Exposure: What Is The Smart Way?”.
In other words, a relevant set of market behavior observations –not only from one market as is typical in trend following– when intelligently combined, allows the opportunity to develop the basis for new solutions. This is quite different from a purely statistical approach, especially at the level of the strategy optimization.
Global Emerging Markets Equities Long/Short Strategy
Examining, for illustration purposes, a proprietary global emerging markets equities Long/Short (L/S) strategy for the period starting in January 2004 up to the 12th of July 2019, including specific costs, we notice the following long-term characteristics:
The result is that over this 15-and-a-half-year time period, global emerging markets equities L/S tripled the Sharpe ratio versus passive long-only (Buy-and-Hold)! At the same time, the result is with a clearly negative beta, meaning the strategy is not only a return enhancer but also a very good diversifier within the same segment.
Regional Perspective Long/Short Strategy
If we switch to a regional perspective with Latin America emerging markets large cap equities L/S for the same period starting in January 2004 up to the 23rd of July 2019, including specific costs, we find the following:
The results at a regional level, when considering the very high Sharpe Ratio, are even better. This is in line with the logic of the market efficiency theories at the regional versus global level. These promote the idea that although there is more volatility and concentration (therefore less efficiency), there is also potentially a greater number of opportunities to be exploited.
A key aspect regarding Long/Short strategies is that the lack of a high ESG level for long-only emerging markets equities is at the same time greatly improved. Why? Because of the following reasons:
- Since a risk-based strategy is not looking for trends, it won't get in a situation in which the strategy reinforces a trend (up or down) that is already in place.
- It is fundamentally a liquidity provider (not a liquidity taker), meaning it benefits the market and should therefore be rewarded correspondingly.
Certainly a fascinating and important topic, we will be discussing ESG more extensively in future articles.
Overall, the risk-based approach adds substantial value particularly at the regional level. Unsurprisingly, the volatility is also a bit higher at the regional level than for the global portfolio. However, volatility in this case is not a good measure of the level of risk.
Global emerging markets equities are more risky than the developed US large cap equities but generate less return long(er) term when remaining passive. This is a typical constellation in which the well-managed short-exposure possibility allows the achievement of abnormal high returns. In addition, the lack of efficiency of the large market makes it possible to obtain a negative beta portfolio, creating an effective diversifier within the asset class.
Does an Emerging Market Investment pay off in the long run?
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