Look for clear entry and exit points when investing in EM says ProMeritum

Pavel Mamai, ProMeritum

Pavel Mamai, founder of ProMeritum Investment Management, a London-based EM sovereign and credit specialist writes on his firm’s approach to the emerging markets.

Wealth Adviser’s readers will be familiar with the case for including emerging markets in any sophisticated investor’s portfolio. Emerging markets are, after all, where most of global growth is going to be coming from in the decades to come. The IMF has estimated that emerging markets economies are likely to grow at two to three times the rate of developed countries like the US.

By some estimates the collective GDP of emerging markets economies including China, India and Brazil has already overtaken that of developed economies. Based on data from the IMF, The Financial Times estimates that by 2020, Asia alone will be larger than the rest of the world combined, in terms of GDP by Purchasing Power Parity.

Emerging markets are also an important source of diversification, particularly in an environment where equity valuations in the US and other developed economies are looking distinctly frothy. In the event of a major correction in the US, a diversified portfolio would cushion the blow.

This train of logic often leads sophisticated investors to allocate to emerging markets through investment vehicles which track emerging markets indices. After all, it is difficult and complicated to invest directly in emerging markets, and such an approach offers broad exposure to the market.

But there are some major flaws to this approach. The consistent feature of emerging markets equities performance is volatility. The main emerging markets indices have been on a roller-coaster ride for decades. For recent examples one need look no further than the MSCI Emerging Market Index, which closed 2018 25 per cent down from its January peak, but has since risen 13 per cent from last year’s October low.

Any investor with broad emerging markets exposure like this would have been up a lot and down a lot, but not consistently and steadily up. Indeed, the present value of an investment made in a fund tracking the MSCI Emerging Market Index in the summer of 2007 would now be worth almost exactly the same as it was 12 years ago, ie no net value would have been added. This is because although there have been many good years, the frequent negative years have been a major drag on long-term compounding performance.

In part this is a reflection of capital markets structures in emerging markets. These are often much smaller as a percentage of GDP than in developed markets. There are not the same levels of transparency and information, or indeed corporate governance. It is also a reflection of the broader vulnerability of emerging markets to macro trends, including exchange rate fluctuation. Movements of the US dollar in particular have a major impact on emerging markets.

So we believe in a different approach. We think the best way to avoid the volatility associated with being passively long is to invest in themes where there are clear entry and exit points. Of course, in order to do so, you have to take a highly disciplined approach to risk management. And you have to understand the dynamics of each situation better than the market.

That sounds like a statement of the obvious, but it is not always clear why emerging markets investors based in London or New York should understand individual national economies better than specialists who are based in those markets, or who are from those countries.

We also believe in sticking to what you know best, in terms of individual geographies, asset classes and sectors. Each country underneath the EM umbrella has its own individual dynamics, the situations in Brazil, Vietnam and Russia, say, are completely different. That is also true of the difference between equity and debt markets.

The space we know best is corporate and sovereign credit. The geographies we know best are the former Soviet Union, sub-Saharan Africa and the Middle East. We have had decades of experience of trading in these markets.  We think by restricting the opportunities we consider to these areas, by sticking to our knitting, we are best able to add value.

In conclusion, we believe that while the case for investing in emerging markets is strong in the abstract, in practice the best way to do is through active management rather than passive; to take advantage of individual situations rather than to be exposed to volatility through long holding periods; to only invest in markets and circumstances you really understand, and to do so with strict risk management and discipline.