Emerging markets growth over the last decade has been tremendous. In the future, as these countries gradually catch up with advanced economies, one can assume that their stock markets will continue to reward investors with strong returns over the long run. Nevertheless, the road ahead is likely to be a bumpy one, as it has been over the past years. Since its inception in April 2003, the ETF EEM (Emerging Market Index) has returned a hefty 22.6% annual return (CAGR), but at the expense of extremely high volatility (36%) and stomach-churning maximum monthly drawdown (-60.4%).
In this post we will highlight how savvy investors can achieve EEM-like returns, with SPY-like volatility and bond-like drawdowns. Seems too good to be true? Then read carefully the following and you will never again consider buying and holding as a option, even if you are crazily bullish for the future. Any investors willing to take some exposure to emerging markets should thoroughly consider the approach detailed here, which is the one we implement at My ETF Hedge Fund.
The figures presented in the reminder of the article are based on a 5-year period backtest (2006-2010) whose purpose is to illustrate the broad principles of the strategy.
1/ Choosing a fair benchmark. In order for the competition to stand a chance, buying and holding EEM will not be our benchmark strategy. We will rather use a simple timing strategy whose rules are: (i) be long EEM when it trades above its 6-month moving average; (ii) be in cash (SHY) otherwise.
We have improved the returns by 60% while decreasing volatility by almost 50% and cutting drawdown by almost 3. Looks like a fair benchmark.
Basically, the idea is to buy every first of the month the two emerging market ETFs of our universe that are ranked highest in terms of risk-adjusted returns, only if their performance has been better than that of plain cash. Otherwise, we stay in cash. Here again, the definition of the ETF universe is key. Our universe has around 20 ETFs, mostly country ETFs of current and future large emerging markets (FXI, INP, RSX, EWZ…).
Such strategy delivered a very strong annual return of around 37% over the last 5 years, with roughly the same volatility as the one of our “upgraded” benchmark and half the drawdowns:
This aggressive strategy may fit well in a diversified portfolio with broad exposure to many asset classes.
3/ The hedged strategies. But more conservative investors can apply simple hedge fund-like techniques to further dramatically reduce both volatility and drawdowns. Of course, there is no such thing as a free lunch in financial markets, so this can only be done by foregoing some upside.
The “strategy hedged 10%” is the one where the emerging market exposure is composed of 3 long positions: 45% in each of the top 2 ETFs and 10% in EUM, which delivers the inverse daily returns of EEM. Note that given the relatively short history of EUM, the data for EUM has been replaced by the inverse of EEM performance, which are not perfect substitutes.
Similarly the “strategy hedged 25%” is long each of the top 2 ETFs (37.5% each) and long EUM (for 25%).
The results are summarized in the table below:
The more conservative of the two above strategies perfectly highlights that it is possible to achieve emerging market-like returns with advanced markets-like volatility and bond-like drawdowns by:
- consistently investing in the top countries or regions with the best relative strength (on a risk-adjusted basis) and
- adequately hedging these positions with an inverse position in the reference index.
This is exactly what absolute return strategies are all about.
The graph below shows the equity curve of the different strategies we talked about in this article. The green line (strategy hedged 25%) is strikingly smooth.
A share of our aggressive portfolio is allocated using the same techniques. We will offer within the next few months access to a premium portfolio in which we do it in a more elaborate way, by varying the size of the hedge (short) position depending on market conditions. This allows us to further improve the risk-adjusted returns of the strategy. For the month of June, we are long IDX (Indonesian Equities) and CHIQ (China Consumer Index). This position is hedged with a position in EUM (short EEM).
As you add more building blocks along these lines for different asset classes and market segments, and dynamically hedge your global portfolio with put options (when volatility is low) or short positions, you can start seeing how ETFs now do allow virtually any investor to manage its portfolio like a do-it-yourself global hedge fund. My ETF Hedge Fund’s purpose is to help you achieve such performance. To be aware of all our portfolios updates, you can subscribe here.
Thanks for reading. Keep posted!