The alpha and beta of emerging markets equities

The appeal of emerging markets is a classic growth story, as starting at a lower wealth level offers a lot of potential for catching up. The problem with growth stories, however, is that investors are often lured into overpaying for growth. This phenomenon is the source of the value premium, which is one of our core quant factors. However, instead of trading at a premium, emerging markets trade at a valuation discount compared to developed markets. Thus, emerging markets appear to be a case of growth – at value prices.

A concern with emerging markets, however, is that they tend to be a bit riskier than developed markets. In efficient markets this higher systematic risk ought to be rewarded with a higher return, i.e. a commensurate risk premium. However, riskier stocks generally do not deliver higher average returns, a phenomenon which is known as the low-risk anomaly.

A good cautionary principle is therefore to focus on safe stocks, and to shy away from the riskier ones. Interestingly, the emerging markets universe contains many stocks that are less volatile than the average stock in developed markets, despite the overall market being somewhat more volatile. Additionally, the volatility of the global equity market portfolio with and without emerging markets is more or less the same, so the risk of emerging markets effectively diversifies away in a global portfolio.

The days that emerging markets are merely providers of basic commodities are long gone. Embraer in Brazil manufactures passenger planes used by airlines around the globe, Korea is known for advanced electronics and cars (with strong brands such as Samsung, LG, Hyundai, and Kia), Taiwan is the main producer of semiconductors, and China is leading with solar panels that are needed for the global energy transition.

From a quant perspective the entire distinction between emerging and developed markets is actually rather arbitrary. The split tends to be based on criteria such as economic development, market size and liquidity, and market accessibility. Of course this all makes sense, but a binary view of emerging versus developed simply does not do justice to the complexity involved. A logical starting point would simply be the all-country (DM + EM) market portfolio containing the full opportunity set, and then thinking about which particular stocks to select from this broad pool.

While until 2010 emerging markets outperformed every developed region by a wide margin, from 2011 onwards they lagged all the other regions. Thus, emerging markets can boost portfolio performance, but they can also be a significant drag. Market timing calls are extremely tough, and the quantitative toolkit is of little use here. Emerging markets have gone from cheap to even cheaper compared to developed markets, which helps to explain their underperformance since 2011. While a reversal is needed, momentum remains weak, and Robeco's Multi-Asset team 5-year outlook is negative. This suggests a neutral position in emerging markets, while acknowledging that timing decisions are challenging. As quants we also tend to be reluctant with country allocation, as even with hindsight it is hard to link long-term country returns to fundamentals.

Quant factors for stock selection have been exceptionally powerful though in emerging markets. Nevertheless, there seems to be a widely held belief that emerging markets are better suited to a fundamental investment approach. But why would that be the case? The classic objection to quant investing in emerging markets equities is that the data quality may be subpar, but this concern seems quite exaggerated.

Moreover, if there are many less knowledgeable investors present in emerging markets then this should not only benefit fundamental professionals, but also quant models that exploit recurring mispricing patterns. Fundamental investors would only have a clear edge if they had access to proprietary, non-public information – in other words, insider trading.

Instead of seeing fundamental and quant as opposing investment approaches, they may actually be mutually reinforcing. To illustrate, Robeco’s fundamental analysts and portfolio managers use quantitative model signals for buy/sell ideation, and their scrutiny has proven very useful for identifying data issues with certain stocks or groups of stocks.

It is easy to dislike emerging markets equities because they have been underperforming developed markets equities for more than a decade, with generally higher risk and lower ESG standards. On the other hand, emerging markets have become an integral part of the global economy, they trade at a large valuation discount, and history shows that they can deliver great performance.

Quant factors are particularly effective in emerging markets, so there is no reason to limit active management to fundamental approaches. Factors offer the highest risk-adjusted returns when applied to stock selection within countries, as opposed to making big risky country bets. Experience and fundamental knowledge are vital to prevent the pitfalls of a systematic investment approach applied to markets that have all kinds of peculiarities.