Alex Christie of J.P. Morgan Asset Management looks at how portfolios can benefit from a defined core allocation to emerging markets.
Exhibit 2, opposite above, summarises the main results of our analysis. In the first column, labelled ‘current’, we show the risk and return characteristics of a hypothetical starting portfolio with a 30% allocation to fixed income, 65% to equities and 5% to real estate.
The following columns show what happens when emerging market equities and emerging market debt are included in the portfolio.
Column 2 shows that when 5% of the portfolio is taken from UK equities and allocated to emerging market equities, the portfolio’s expected return rises by 1.9% while the potential loss rises also by 1.71%.
The return per unit of risk, however, improves from 0.159 to 0.161. As the allocation to emerging market equities increases to 10%, the portfolio’s return per unit of risk rises to 0.162. Columns 3 and 4 show the impact of a 5% and 10% allocation to emerging market debt, taken from UK gilts and UK corporate bonds.
The portfolio’s expected return rises by 1.9% and 4.4% respectively, while the potential loss falls by 1.12% and 0.03%, thereby improving the portfolio’s efficiency.
In all four cases, therefore, the inclusion of emerging markets – whether equities or bonds – in a portfolio tends to increase efficiency.
We extended this analysis and measured the impact of investing in both emerging market equities and emerging market debt in varying proportions.
Our analysis illustrates that the simultaneous allocation to emerging market equities and emerging market debt increases the return per unit of risk relative to the starting portfolio.
A summary of our findings is reported in the last two columns in exhibit 2 – the largest improvement to the return per unit of risk in this hypothetical setup is in the case of a 10% allocation to both emerging market equities and emerging market debt.
It is important to note that the improvement in the return per unit of risk is sensitive to the return assumptions used in the model, and to which assets are replaced with emerging market assets.
Beyond a certain allocation threshold to emerging markets, the increase in return per unit of risk begins to diminish – a result not unique to emerging market assets. With these caveats in mind, though, we can conclude that the return per unit of risk can potentially increase when emerging market equity and debt are added to a portfolio.
Conclusion
As financial markets have stabilised after the financial crisis, emerging and developed markets have again begun to decouple, affording investors the opportunity to reap the benefits of higher expected emerging markets GDP growth and differentiated sources of return.
Our analysis demonstrates the value in having a defined core allocation to emerging market assets, suggesting that a material allocation to emerging market equities and debt as part of a multi-asset portfolio has the potential to boost returns and provide diversification benefits over the long term.
