Factor investing since the early 1990s has been a popular approach to target some of the systematic sources of return common across asset classes in developed markets. With traditional return sources under stress, many investors are focusing narrow targets on rising markets in a quest for new growth and diversification opportunities. In this final part, I will take a journey to the other side — emerging markets (EM) in both its rewards and risks.
Understanding Factor Investing
Technological advances in research have made factor investing possible, but this post will leave the details of that to a later date (or another blog). Here the idea is to focus on individual characteristics or “factors” that account for disparities in stock pricing. Common factors include:
VALUE: the most interesting characteristic of these stocks is that they seem to be undervalued against their fundamentals.
Momentum: Picks the stocks, that were extremely gainers in the last few days.
Grade: Companies with healthy balance sheets and focus on repeatable business
Size: Small may do better than large [The Economist]
Value: Stocks with low price volatility
Studies have found that these elements generate a premium over time in developed markets. Well, do they work in emerging markets, and if yes how?
The Appeal of Emerging Markets
The increase in factor investing presents several appealing characteristics for the emerging markets:
More Upside: In general emerging markets grow much faster than developed ones translating into higher return opportunities.
Inefficiencies: Skilled investors can capitalize on mispricing in less efficient markets
Emerging Market Diversification: Emerging markets may provide diversification as low correlation with developed countries,
Factor Performance in Emerging Markets
The studies suggest that many of the factors on which expected returns in developed markets are based also yield abnormal positive returns in emerging markets. That being said the size and consistency of these returns are not standard:
Source: Factor ResearchNonetheless, the value factor has displayed powerful return characteristics in emerging markets and frequently outperformed its developed market sibling.
Momentum: Momentum has worked (though it would be likely to suffer more from crashes during reversals)
Quality: Quality has long been a strong factor in emerging-market investing, particularly during market downturns.
Scale: there remains a small size effect, and it might be more subdued internationally than in the US.
Low Vol: This factor has exhibited strong diversification benefits, delivering lower portfolio volatility for a given level of return.
Unique Risks in Emerging Markets
Factor investing in emerging markets carries rewards, but it also poses unique risks.
Political and regulatory risk: Political instability and a fluid legislative landscape can be more common in developing markets.
Currency risk: For foreign investors, exchange rate fluctuations can have a very large impact on returns.
Liquidity risk: The liquidity of many emerging market stocks tends to be lower than those in the developed market.
Data quality and availability: Historical information in emerging markets can be less reliable or complete than elsewhere.
Market concentration: In some emerging markets few large companies or sectors dominate the market and can influence factor returns.
Cost implementation: Execution costs and strategy profitability are impacted by the higher trading cost, and market impact often observed in EM.
Implementing Factor Strategies in Emerging Markets
In light of those risks and challenges but also opportunities, how can investors successfully apply factor strategies in emerging markets?
The above advice is based on the Philippine equity market but it remains true: Diversify (spread across multiple countries/sectors) to avoid risks that may be country-specific.
Robust Screening: Use stringent criteria and avoid the least liquid stocks.
Multi-factor model: Blending multiple factors to potentially produce higher return and lower risk.
Discretionary allocation: Change factor Exposures dynamically as per the market conditions and evaluation levels.
Local expertise: Localise with managers who have local knowledge
Risk management: Enforce stringent risk controls; e.g., Stop loss orders and position limit.
The Future of Factor Investing in Emerging Markets
Investors could be well served by applying a factor investment approach to their emerging market allocations, an area where opportunities are likely to expand as these markets evolve and integrate with the global financial system. Still, it would be wise for investors to monitor the distinct risks of these markets.
Factor strategies could also be enhanced by technological advances such as machine learning and big data analytics, which may enable the discovery of additional patterns or improve implementation efficiency. Also, now that more investors are utilizing these strategies it will be important to keep an eye on whether factor premiums continue and if so at what rate.
Conclusion
Factor investing in emerging markets is an attractive investment opportunity for those investors looking for higher risk-adjusted returns and diversification. The potential rewards and reach are high, but so are the risks. To succeed in this field, one needs a broad and thorough experience both of factor investing principles as well as the characteristics associated with emerging markets.
Just like any investment strategy, due diligence and smart execution as well as appropriate risk management is key. For those who can deal with navigating complexity, factor investing in emerging markets could provide a welcome hold-out if incorporated along any traditional set of asset holdings.
Investors should carefully assess their risk tolerance and investment objectives before entering into this domain. Investors should consult with financial professionals who are experienced in factor investing and emerging markets, as always, before making any investments.