Emerging markets have had a rough time over the last year. The sheer announcement and subsequent implementation of tapering by the US Federal Reserve has exposed key vulnerabilities in their economies. Many investors have suffered doubly, as in some cases capital losses have been compounded by the eroding effects of local currency depreciation. Similarly to the effects the Eurozone debt crisis has had in the investors’ psyche, the events of the last year have come to severely weaken one of the mantras of the investment world of the last two decades, namely that individual country risk was no longer relevant when considering a play on emerging markets.
Plaudits for the BRICS have given rise to concerns
Indeed, for many years, emerging markets have been classed as something of a harmonised asset class, underpinned on the basic principle of the stability borne out of economic and political reforms. Over the last year, key fault lines have been exposed, and plaudits for the BRICS have given rise to concerns about the likes of the “fragile five”. Investors are now routinely advised to be discriminatory whenever approaching emerging markets, clearly distinguishing between those countries still considered relatively safe and those posing substantial risks.
The dividing line between the two camps seems to be clearly defined by the combination of three macroeconomic variables: national budget, current account, and foreign reserves positions. There are different views as to what quantitative combination of these variables might push an emerging economy into the safe or the risky buckets. However, any emerging economy unable to cover a current account deficit - let alone that and also a national budget shortfall - with available foreign exchange reserves is now considered a much higher investment risk.
Discrimination of any kind always poses particular challenges for investors favouring the passive fund route. Indeed, while those investing via actively-managed funds should – at least theoretically - count on the fund managers’ ability to rebalance portfolios to reflect the market’s shifting sentiment; those investing via passive funds – whether traditional trackers of exchange traded funds – are constrained by the exposure afforded by the benchmark the funds chose to track. And in many cases, particularly so in the case of mainstream emerging market benchmarks, effective country discrimination can be sorely lacking.
A quick scanning through of the index-tracking fund universe in Europe reveals that country discrimination for emerging markets is primarily addressed by equity funds. Although more granularities might be desirable, investors do have the choice of individual, regional and acronym-based emerging market equity exposures to choose from. ETF providers have led the way on this front, but, although with a more limited choice in the total number of funds, traditional index trackers also follow this pattern.
By contrast, when it comes to emerging market fixed income, country discrimination in indices – and thus in the passive funds – is largely absent. In practical terms this may not be much of a problem at this juncture, as most investors are likely to have an equity market bias. However, this should not deter us from highlighting all potential shortcomings.
Investing in passive funds is rationalised on the principle that active fund managers are extremely unlikely to beat “the market” on a consistent basis, even when it comes to asset classes, such as emerging economies, where active managers may be able to exploit market inefficiencies. However, investing in passive funds does not mean that one should place blind faith on the virtues of the benchmark measuring the performance of any given market. Indeed, investing passively should never be taken as a licence to become a passive investor. Quite the opposite, in fact. Investors using passive funds must take a very proactive interest in ensuring that their chosen funds are referenced to indices that accurately reflect their asset allocation wishes.
This article originally appeared in Professional Paraplanner magazine
