| Emerging Markets Investing: Opportunities and Challenges |
Investors have been turning to EM investments as a means to increase return potential in their portfolios and to improve diversification versus investments tied to developed economies. However, investors are challenged by the need to navigate the fluid risks which can have a detrimental impact on performance. Moreover, they may not be well equipped to exploit the significant opportunities that arise across the EM universe.
Strong fundamentals in emerging markets, both in absolute terms and relative to developed economies, support the attractive return potential associated with EM investments. Emerging countries are well positioned to have the potential to continue realizing high future growth rates, bolstered by secular tailwinds of lower debt burdens, younger populations, expanding middle classes and productivity gains in the workplace. This is in contrast to the developed world, which faces structural headwinds to growth in the form of higher debt burdens, aging populations and fiscal constraints. Stronger EM fundamentals are further supported by long-term investor demand trends, as investors in both EM and developed countries increase strategic allocations to the various EM asset classes. These factors underpin an EM investment environment characterized by rising asset prices, appreciating currencies and bond yields that also have the potential to converge toward developed bond yield levels.
However, investing in emerging markets is not as simple as taking a buy-and-hold approach. First, there are multiple EM asset classes to consider beyond the broad equity category. Each presents different risk/return profiles, and their relative attractiveness varies over the course of a cycle. Second, the EM world is not homogeneous. While some countries are strongly positioned with fundamentals that are clearly ahead of the rest, others still present considerable risks. The same is true on a corporate level. Third, investors need to remain cognizant of risks that are unique to EM investing. Even though the EM investment universe has a range of distinct asset classes, they all exhibit a positive correlation to each other. In other words, they share a common underlying risk factor. This is in contrast to the developed world, where stocks and bonds tend to better diversify each other. Finally, as compared to developed markets, EM remains a more volatile investment overall, and one in which tail events, or sudden market shocks, have been more prevalent. |
| A Comprehensive Emerging Markets Solution |
PIMCO designed the Emerging Multi-Asset Strategy to serve as a comprehensive EM portfolio solution for investors, one that seeks to simultaneously manage the opportunities and challenges associated with investing in emerging markets. Beyond simply providing exposure to the key EM asset classes – equities, local sovereign debt, external sovereign debt, corporate debt, currencies and tactical commodities exposure – the Strategy also incorporates three distinguishing sources of active management:
- “Top-Down” Asset Allocation Decisions – driven by PIMCO’s global macroeconomic views, using a risk factor framework. These asset allocation “beta” decisions are implemented across the range of EM asset classes – equities, fixed income, currencies and tactical commodities exposure – in a manner that best achieves PIMCO’s risk factor targets.
- “Bottom-Up” Relative Value Strategies – driven by PIMCO’s deep EM expertise in each asset class. These “alpha” strategies seek to add excess return beyond the asset allocation decisions.
- “Tail-risk” hedging strategies – incorporated and actively managed in an effort to further increase long-term return potential by seeking to limit losses from periodic market shocks.
By combining these elements into a single portfolio, the Strategy is able to offer investors a comprehensive solution that combines the strategic exposure across EM asset classes that investors desire with a robust risk management return-seeking framework, as outlined in Chart 1 below.
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| Investment Process |
The investment process for Emerging Multi-Asset builds off the forward-looking views produced by PIMCO’s secular and cyclical investment process. This process begins with PIMCO’s three- to five-year secular outlook, which identifies key longer-term trends, risks and opportunities across the global economy. It is supplemented by PIMCO’s cyclical outlook, which specifies a near-term forecast by assessing drivers and risks to economic growth and inflation in key regions globally, including EM. PIMCO’s Investment Committee then combines these “top-down” macro views with “bottom-up” inputs from the firm’s sector and regional specialist portfolio management teams. The result is a series of forward-looking investment views regarding the attractiveness of key global risk factors, which can be expressed across and within a range of asset classes.
Building off this firm-wide process, the Emerging Multi-Asset portfolio management team then applies a three-step investment process specific to the Strategy:
- Build the “Beta” – The portfolio management (PM) team combines the firm’s secular and cyclical investment views with their deep collective EM expertise to determine the target asset allocation mix within the Strategy. Specifically, these “top down” inputs are used to establish overall risk targets, as well as preferred regions or countries, industries and currencies. Concurrently the PM team develops “bottom up” views on earnings growth, equity multiples, interest rates, currencies and credit spreads within the EM universe. These inform the return forecasts for each underlying asset class by identifying what risk factor within each asset class is likely to drive that return.
For example, if the team develops a view that EM equities are likely to gain value, and that gain is expected to be primarily driven by currency appreciation, then the team may alternatively consider locally denominated debt or direct currency exposure as a preferred way to access that return-generating risk factor. PIMCO’s risk factor framework for asset allocation is a distinguishing approach in that it recognizes that risk exposures within asset classes explain the majority of returns, and that different combinations of asset classes can provide more effective targeting of desired risk factor exposures, consistent with PIMCO’s forward-looking views.
- Add the “Alpha” – The PM team looks to increase excess return potential by incorporating relative value “alpha” strategies from within each of the underlying EM asset classes. These are incorporated in two ways. First, each underlying PM will express strategy-specific relative value views within the underlying asset classes in which each specializes. Second, select strategies are amplified at the overall Strategy level, based on the PM team’s conviction and the volatility and correlation characteristics of the position relative to the total portfolio.
- Hedge the “Tails” – As a final step, PIMCO incorporates tail-risk hedges, recognizing that risk in financial markets is not normally distributed. The goal is to further increase long-term return potential by limiting losses associated with periodic market stress. By actively managing a mix of portfolio hedges, PIMCO seeks to identify cost efficient positions that have the potential for outsized gains should EM asset classes lose value amid market stress. In addition to mitigating losses, these tail risk hedges may also enable the PM team to acquire additional high quality positions at distressed prices during a crisis, which can further enhance long-term return potential.
By combining these three components of the investment process – “top-down” asset allocation, “bottom up” alpha strategies, and “tail-risk” hedging – PIMCO seeks to better manage risk and deliver incremental returns over a passive buy-and-hold investment approach.
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| The Importance of “Tail-Risk” Hedging in Emerging Markets |
| Market shocks, also known as “tail-risk” events, occur with surprising frequency in emerging markets. Chart 2 provides a list of the major “tail-risk” events that have occurred over the past several decades that were particularly relevant for emerging markets.
Traditional risk management approaches and pricing models tend to underestimate the frequency and severity of these events, and by extension, their potential detrimental impact on portfolio returns. Investors who fail to account for this investment reality, or who hope to use a “just-in-time” portfolio risk-management approach, may find it challenging to achieve their long-term investment objectives. The need for efficient, strategic tail-risk management is, we believe, an important pillar for successful EM investing.
The tail-risk hedging component of the Strategy is designed to provide “offensive portfolio hedging.” Not only does it seek to hedge the portfolio from the potentially severe effects of market accidents and policy mistakes, it also helps add exposure to high-quality assets that have the potential to be attractively priced as a result of broader market stress.
PIMCO evaluates a wide range of extreme scenarios and available tail-hedge instruments to determine an optimal hedged portfolio, balancing cost and potential payoff. In so doing, PIMCO’s tail-risk management strategies are a critical component for both preserving and enhancing potential portfolio returns over a business cycle. |
| PIMCO Emerging Multi-Asset Strategy Team |
A four-person portfolio management team is responsible for integrating PIMCO’s investment views and constructing the portfolio. Curtis Mewbourne serves as the portfolio manager responsible for overall asset allocation decisions and alpha strategies. Masha Gordon leads the active EM equity team, while Ramin Toloui and Michael Gomez manage EM external debt and EM local debt, respectively. The Strategy’s four person portfolio management team integrates seamlessly with PIMCO’s broader asset allocation and tail-risk hedging teams to ensure alignment with firm-wide views and consistency with other PIMCO asset allocation strategies, to the extent applicable.
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Incorporating the Strategy in an Existing Asset Allocation
Portfolio |
Investors can incorporate the Emerging Multi-Asset Strategy in their existing asset allocation portfolios in multiple ways.
- Comprehensive EM Allocation Solution: Emerging Multi-Asset Strategy is designed to be a comprehensive emerging markets asset allocation solution. It can serve as a consolidating strategy for investors who don’t want to make individual allocations to the various EM asset classes, or are looking to replace a static EM allocation with a dynamic, risk-managed approach. The strategy may also be a good fit in cases where investors want to control the long-term asset allocation to EM equity and debt, but are looking to delegate the tactical weighting around that long-term asset allocation to PIMCO. As such, investors looking to allocate to the Emerging Multi-Asset Strategy without altering their EM asset allocation mix can do so by simply taking assets proportionally out of their current allocation to EM asset classes.
- Potential Replacement for EM Equity: Investors seeking upside participation in EM but concerned with downside risk may consider replacing part of their existing EM equity allocation with the Emerging Multi-Asset Strategy.
- EM-focused Alternatives Strategy: Emerging Multi-Asset Strategy can be used as a liquid, potentially lower-fee substitute for an EM-focused hedge fund. Thus, investors may consider utilizing the strategy in their “alternatives bucket.”
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