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Emerging markets exposure with less of the risk

Ian Pascal 450

The long-term investment case for having exposure to emerging markets is well established. Emerging markets can deliver strong returns, underpinned by strong economic growth. While past performance is not a guide to future performance, we believe that asset returns in emerging economies will continue to outperform returns in the developed world over the medium and long-term.

However, emerging markets can be volatile. For many investors, it is a level of risk that they are uncomfortable with. After all, one disappointing year in emerging equity markets can erase several years of steady gains.

But it is possible to combine the principles of a multi-asset approach with the prospect of long-term capital gains from emerging markets. By dynamically allocating across a range of asset classes, including emerging equities and bonds, developed market bonds, currencies, commodities and cash, we aim to provide investors with the long-term returns associated with emerging equity markets, but within defined risk guidelines.

We aim to achieve this by using the same tactical asset allocation process that we apply to all multi-asset portfolios. We follow a top-down approach to investing that we believe is the most important generator of returns.

We respond to changing macro environments by dynamically allocating to different asset classes at different times. We are not obliged to invest in any one asset class and we only invest in assets that we believe will deliver returns or reduce risk.

Our investment process starts with calculating the likely return, correlation and risk factors for each individual asset class. We then determine an asset allocation for the portfolio to meet the objectives, which is then reviewed and adjusted by the investment team. We call this the 10-year optimal strategy, and while this is not a benchmark, it is the strategy that we believe has the best chance of delivering our target risk and return over a 10-year period. Since we know that markets deliver returns unevenly through the business cycle, we adapt the asset allocation, aiming to generate investment returns when they are available, then reducing risk when market conditions dictate.

The combination of strategic and tactical asset allocation can limit volatility, helping us to reach our aim of capturing the long-term returns associated with emerging equity markets, but with less than emerging market equity risk. Our experience suggests that if we can get the big decisions right, we can generate attractive long-term returns.

We believe it is important to be able to invest in developed market assets such as US treasuries alongside emerging assets in the portfolio, with the aim of reducing portfolio risk and managing volatility during periods of heightened risk. The same thinking is behind our ability to allocate to diversifying assets such as gold bullion, which have relatively low correlations to other asset classes.

No approach can eliminate risk when investing in emerging markets. It is possible to manage these risks through dynamic asset allocation, but investors considering any emerging market multi-asset strategy would do well to consider the risks carefully before investing.

Ian Pascal is head of marketing and communications at Baring Asset Management


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