Monday, April 9, 2018

Downside protection is important in the emerging markets

Photo: iStock/Ildo Frazao
By Timothy Atwill, Guest Columnist

To state the obvious, emerging market equities are risky. Investors are exposed to extreme levels of unpredictability due to elevated levels of political, currency and liquidity risk. However, there is a little-known characteristic of this asset class that further reinforces this notion of risk—emerging markets routinely experience large drawdowns. And these drawdowns should have emerging market investors considering strategies that structurally offer downside protection.

In fact, in every calendar year since 2001, the MSCI Emerging Markets Index has posted a market drop exceeding 10 percent, with nearly half of these drawdowns exceeding 20 percent. Perhaps most surprising, these drawdowns can happen even during particularly bullish calendar years. For example, 2004, 2006 and 2009 all experienced calendar-year index returns exceeding 25 percent, but they also experienced maximum drawdowns exceeding 20 percent. 

If a 20 percent drop indicates a bear market and a 20 percent gain indicates a bull market, this means emerging market investors experienced a bear market on their way to booking a bull market return for each of these three years. Now that’s volatility!

Return and Maximum Drawdown for the MSCI Emerging Markets Index, by Calendar Year, 2001-2017

Source: MSCI, Parametric, as of 12/31/2017
For illustration purposes. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index. Click on the image to access a larger version.

Examining the entries in the above table, one can make two further observations. First, 2017 is highly unusual for its lack of a major drawdown. In fact, the asset class had only one down month over the course of 2017. Looking at the historical record, it would be quite unusual for a significant drawdown to not occur in 2018. This is not a timing call, but simply a restatement of the fact that the emerging market asset class typically experiences a 15 to 25 percent drop in any given year. 

Given this history of frequent and material drawdowns, investors should be interested in how their emerging market investments respond to drawdowns. Because many passive strategies contain a material concentration of country-level exposures, we would note that broad diversification at the country level has historically been quite powerful in helping to provide downside protection in the emerging markets.

There are two benefits of strategies that offer downside protection. First, they allow investors to be less panicked when such drawdowns occur, which helps them stay invested. Second, and more importantly, such strategies can potentially produce strong relative returns. By helping preserve capital in drawdown periods, they allow investors to participate more fully in any ensuing rally. 

As recent days have shown, the lack of volatility seen in 2017 is unlikely to continue through 2018. Accordingly, investors should re-examine the downside characteristics of their emerging market managers because staying invested in times of sudden sharp losses will be key to success in 2018.

The views expressed do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Parametric or TEXPERS.

Timothy Atwill
About the Author
Timothy Atwill is head of the investment strategy team at Parametric. The team is responsible for articulating and evolving Parametric's current investment strategies. In addition, Atwill holds investment responsibilities for Parametric's emerging market and international equity strategies, as well as shared responsibility for the firm's commodity strategy. Prior to his role with Parametric, Atwill worked at Russell Investments in the company's manager research unit and in Russell Investments' trading group, implementing derivative strategies for institutional clients. Prior to his time at Russell, Atwill worked as a nonlife actuary and derivatives portfolio manager at Safeco Insurance Co.

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