Finding the emerging-market middle path through factors

With the right multi-factor ETF, investors can get EM exposure but still enjoy a relatively smooth ride

Finding the emerging-market middle path through factors

Among Canadian investors, there’s an understandable bias toward Canada-listed securities and financial products. When it comes to international diversification, the tendency is to go south of the border and access the deep and developed U.S. market.

Ask them to consider venturing into emerging markets, and many investors will shy away, particularly in light of the uncertainty and the pervasive risk-off sentiment around the world. But to Ahmed Farooq, vice president for ETF Business Development at Franklin Templeton Canada, you stand to miss a lot when you make that choice.

“I think emerging-markets exposure is worth considering for your portfolio, even albeit the risks that are involved,” he told Wealth Professional. “Of the 7.5 billion people living in the world right now, 78% still live in EM countries. And when you think about demographics, 49 million Americans are now over the age of 65, while 50% of India’s population is under the age of 34, so emerging markets have a lot of potential advantages as long-road-type investments.”

“Emerging markets” is a loaded phrase, and what counts as an emerging-market country may differ among index providers. Farooq noted that while FTSE Russel considers South Korea as a developed market, MSCI still puts it squarely in the EM bucket. There’s also a question of whether China holds too much sway as it can get a 35% to 40% weighting in popular EM indexes; based on its own analysis, Franklin Templeton pares down China’s exposure in its EM strategies to as low as 19%.

“There are so many different ways to slice and dice emerging markets,” Farooq said. “It’s always important to think about the outcomes you want from your portfolio, and how you want to get access to them.”

Read also: Working toward a more definite EM classification scheme

From an ETF perspective, investors looking for EM exposure broadly have three different paths to choose from: purely passive index-based strategies, active stock-picking mandates, and factor-based products. Factor strategies can be further separated into single-factor products — those that focus on a particular factor like value, quality, or momentum — and multi-factor strategies that blend different factors together.

“There’s a lot of volatility that comes with pure passive exposure to emerging markets,” Farooq said. Aside from being momentum-driven, the segment tends to be sensitive to the US dollar; there’s also its traditional dependence on commodities and increasing ties to information technology.

An active EM strategy comes with its own volatility: even the most disciplined stock-picker is not likely to come up with a portfolio with stable returns, particularly if they’re trying to beat the market. So for investors looking for EM exposure and a smooth ride over the long term, factor investing could present an ideal solution.

“The great thing about a factor strategy is that it lets you favour certain outcomes,” he said. “If you look at the top 10 holdings of passive EM funds, you’ll usually find they’re all tech companies. But with factor strategies, you can be more specific about whether you want quality companies, low-vol companies, small-caps, value, dividend, or momentum.”

While investors can choose to focus on single-factor strategies, Farooq cautioned that each one comes in and out of favour depending on the phase of the market cycle. Major political events — the upcoming federal election, the hard Brexit, and the US elections next year come to mind — could also play a role. Success becomes a matter of timing, something that even the most hard-boiled active investors don’t profess to have down pat.

“With a multifactor strategy, you can look to smooth out that performance by not putting all your eggs in one basket,” he said. “And it all comes in one ticket.”

Following the outcome preferences generally expressed by the advisors and clients they work with, Franklin Templeton’s multifactor strategy puts a heavy weight on the quality factor, favouring companies with sound business models. Value takes second priority, despite its much-reported underperformance, based on a conviction that undervalued companies that offer dividends are worth holding. A modest allocation to momentum ensures that investors get a piece of any action that’s occurring in the market, and exposure to low volatility stocks provides a measure of stability and safety.

“What people really have to think about is what return outcomes they’re looking to have achieved in the portfolio, and consider what they’re willing to give up in exchange for downside protection,” Farooq said. “That’s what multifactor strategies are trying to achieve.”


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