115) Global exposure: Enhancing returns from the emerging markets

The market has seen the launch of handful of global equity funds in recent times. Exposure to global equity should be viewed as a returns-enhancing strategy and not as a portfolio diversification measure. This article suggests an optimal portfolio construction process and explains why the global portfolio exposure should be restricted to emerging markets.

The Indian mutual fund industry has realised the importance of offering investors exposure to global equity markets. Several asset management firms have launched global equity funds since 2007.

At present, there are a handful of choices, ranging from Franklin Templeton’s Asia Fund to Birla Sunlife’s International Equity Plan, and some in between.

Investors often ask if constructing a global portfolio makes economic sense as a diversification measure.
This article aims to address the above question. Specifically, it shows that exposure to global equity is not a diversification measure but an optimal way to enhance portfolio returns.

It also shows why Indian investors should take global exposure to emerging markets and not to developed markets. The article also provides some suggestions on the portfolio construction process.Diversification?

Till the early 1990s, asset prices in most home markets had low co-movement with those in the other markets. This provided a case for portfolio managers to invest in global equity.

Of late, the rationale for global portfolio has been called to question. The reason is not far to seek. Globalisation has a side-kick — the contagion. When a major stock market tanks due to a financial crisis, others simply follow. The sub-prime crisis in the US is a case in point.

This contagion effect has led many to conclude that investing in global markets no longer offers an advantage over the home market.

Besides, the high co-movement among various global equity markets has led to weakening in relationship between stocks and bonds in the home market. So, the argument is that portfolio managers can engage in asset allocation in the home market as a diversification measure.

This argument against a global portfolio misses a point. A high co-movement between Indian and, say, Brazilian markets does not mean same returns in both the markets.

Besides, the co-movement is not so strong during normal market conditions. And it is this relationship that a portfolio manager is expected to exploit. Our argument for global portfolio, in any case, extends beyond the diversification principle.

Enhancing returns

It is optimal to construct a portfolio with a primary objective of maximising returns with appropriate risk management rules instead of adopting a diversification strategy that aims at minimising risk. A global portfolio fits within this returns-enhancing framework.

Asset prices in the emerging markets have typically outperformed those in the developed markets such as the UK and the US. A global portfolio exposure for an Indian investor within the returns-enhancing framework should, hence, be restricted to the emerging markets.

India has been one of the best performing emerging markets in recent times. The asset price growth could, however, slow down in the coming years.

An exposure to other emerging markets, therefore, provides a case for lifting the portfolio returns. For instance, the Brazilian or the Russian market could be on an uptrend when the Indian market is down for a country-specific reason.

Besides, it is important for a portfolio manager to generate alpha returns — the excess returns generated because of the manager’s skill.

There is a higher level of noise trading in emerging markets such as Pakistan and Russia.

This pushes assets to wander far away from their estimating intrinsic value providing a case for generating alpha. The developed markets do not present such a rich alpha-harvesting opportunity.

Global portfolio structure
So, what is the best composition for this global portfolio? Portfolio managers typically assign weights to each market and then pick the best stocks in each market.

This approach was optimal when the primary reason for a global exposure was portfolio diversification.

The emphasis here is to enhance returns. So, sector allocation is more important than country allocation. The portfolio construction process should not bolt together the Indian market and, say, the Indonesian market citing the low co-movement between the two during normal market conditions.

If the portfolio manager is of an opinion that the telecom sector is likely to do well, she should take exposure to the best stocks in that sector across emerging markets. Such an exposure could be, say, in an Indian company and a Taiwanese company.

So, if the telecom sector does well, the global portfolio would benefit because of its exposure to the Indian and the Taiwanese company.

If the Indian telecom stock is down for a country-specific reason, the global portfolio would still benefit if the Taiwanese stock is on the uptrend. If there is a contagion, the global portfolio will, however, decline.

It is, therefore, important for investors to buy global funds that take exposure in growth sectors across emerging markets.

Fund-houses should launch more funds to exploit alphas in the emerging markets. The objective is to enhance returns with appropriate risk management rules, not diversify risk.

B. Venkatesh

(The author is an investment strategist. He can be reached at enhancek@gmail.com)