Factor premiums can be found in stock markets across the world, including emerging markets. But does factor allocation in emerging markets really add value to a global equity portfolio in practice? The short answer, we argue, is yes.
In a recent research note, we investigated whether allocating part of an investor’s portfolio to emerging markets equities adds value to a global equity portfolio. Using market data over the period from January 1988 to December 2017, we investigated whether investors should allocate to emerging stocks and how they should go about it.
More specifically, we considered two main options. The first is based on a passive allocation that replicates the MSCI Emerging Markets Total Return Index. The second involves allocation to the well-known value and momentum factors, within the MSCI Emerging Markets Total Return Index investment universe, using a ranking approach, as well as relatively simple factor definitions and portfolio construction rules (investing in the 33% most attractive stocks from a factor perspective, with monthly rebalancing).
The gains of allocating to EM are far greater when value and momentum are taken into account
We found that, historically, allocating part of an investor’s portfolio to passive emerging markets equities increased the portfolio’s risk-adjusted return. However, the gains of allocating to emerging markets are far greater when value and momentum factors are taken into account in the stock selection process. The benefits of allocating to factors in emerging markets can be significant, even when factor investing is already implemented in the developed markets part of the portfolio.
In our analysis, we also considered more sophisticated portfolio construction rules that do not entail the immediate sale of stocks that become less attractive in terms of factor exposure. Instead, every quarter, only stocks that are no longer among the top 50% are sold. These stocks are then replaced by the most attractive stocks at that time not yet included in the portfolio. Our calculations showed that compared to a more static approach, this dynamic approach leads to both lower turnover and higher returns.
Based on prudent assumptions, we also looked at the impact of transaction costs and management fees on performance. More specifically, we assumed trading costs of 30 basis points for developed markets stocks and 50 basis points for emerging markets stocks. We also assumed annualized management fees of 10 basis points for passive developed markets, and 20 basis points for passive emerging markets. An additional 10 basis points per annum mark-up was included for the factor portfolios. Our conclusion is that even once these costs have been incorporated, allocating to emerging markets factor premiums still adds substantial value.
Finally, we analyzed the performance of the different investment strategies over two equal sub-periods: from January 1988 until the end of 2002 and from 2003 until December 2017. The results in both sample periods were in line with the findings for the overall sample. Allocating to emerging markets improved the Sharpe ratio of the portfolio in both sub-periods, and allocating to the value and momentum factors further improved the Sharpe ratios.
As result, we advise investors to allocate part of their portfolio to factor premiums in emerging equity markets, all the more so given that the factor definitions used in our study are relatively simple. We argue that efficient factor investing strategies using enhanced factor definitions, as well as smart rules for stock selection and portfolio construction, can achieve even better investment results, while lowering both risks and costs.
Robeco has been successfully running factor-based portfolios in emerging markets for over ten years now. Since its launch in 2008, our Active Equities strategy has proven its ability to consistently and significantly outperform the MSCI Emerging Markets Index, both in up and down markets, delivering positive excess returns in eight out of nine full calendar years.
This report is not available for users from countries where the offering of foreign financial services is not permitted, such as US Persons.
Your details are not shared with third parties. This information is exclusively intended for professional investors. All requests are checked.
The Robeco Capital Growth Funds have not been registered under the United States Investment Company Act of 1940, as amended, nor the United States Securities Act of 1933, as amended. None of the shares may be offered or sold, directly or indirectly in the United States or to any US Person.
This website is intended for use only by non-U.S. Persons outside of the United States (within the meaning of Regulation S promulgated under the Securities Act of 1933, as amended (the “Securities Act”)) who are professional investors. By clicking “I Agree” below and accessing the information on this website, including any subdomain thereof, you are certifying and agreeing to the following: (i) you have read, understood and agree to this disclaimer, (ii) you have informed yourself of any applicable legal restrictions and represent that by accessing the information contained on this website, you are not in violation of, and will not be causing Robeco or any of its affiliated entities or issuers to violate, any applicable laws and, as a result, you are legally authorized to access such information, (iii) you understand and acknowledge that certain information presented herein relates to securities that have not been registered under the Securities Act, and may be offered or sold only outside the United States (within the meaning of Regulation S under the Securities Act) and only to, or for the account or benefit of, non-U.S. Persons (within the meaning of Regulation S under the Securities Act), (iv) you are a non-U.S. Person (within the meaning of Regulation S under the Securities Act) located outside of the United States (within the meaning of Regulation S under the Securities Act) and (v) you are a professional non-retail investor.
Access to this website has been limited so that it shall not constitute directed selling efforts (as defined in Regulation S under the Securities Act) in the United States.
Nothing contained herein constitutes an offer to sell securities or solicitation of an offer to purchase any securities in any jurisdiction.
We reserve the right to deny access to any visitor, including, but not limited to, those visitors with IP addresses residing in the United States.This website has been carefully prepared by Robeco Institutional Asset Management B.V. (Robeco). The information contained in this publication is based upon sources of information believed to be reliable. Robeco is not answerable for the accuracy or completeness of the facts, opinions, expectations and results referred to therein. Whilst every care has been taken in the preparation of this website, we do not accept any responsibility for damage of any kind resulting from incorrect or incomplete information. This website is subject to change without notice. The value of the investments may fluctuate. Past performance is no guarantee of future results. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. For investment professional use only. Not for use with the general public.