In a cycle with precious few highlights, one of the brighter spots has been the emerging markets universe. Indeed, for most of the last year emerging markets--led by Latin America--has been the top performing asset class. But while market-leading performance is always tempting, the appeal to advisors should be the long-term diversification benefit this highly volatile asset class offers.
In our view, the real story in emerging market investing is its correlation--more specifically its lack thereof--with domestic equities. Over the last 10 years, the rolling three-year R-squared between the Russell Emerging Markets Large Cap Index and the S&P 500 has ranged from 0.30 to 0.75. Without argument, the asset class provides an excellent diversification tool for a well constructed portfolio. Unfortunately, it's also without argument that emerging markets are more difficult to tap into than any other asset class.
While it's possible to create a portfolio of international stocks in a separately managed account through the use of American Depository Receipts (ADRs), or even developed country ordinary shares with a high enough minimum investment (roughly $5 million), neither approach is possible for an emerging markets portfolio. Operating expenses put a direct account out of reach for any but the largest institutions. In the end, while a mutual fund may not be the preferred investment vehicle to access emerging markets, it is the best and very likely, the only way for most clients.
The good news is that the process for choosing a fund in the emerging markets space is fundamentally no different than choosing one in any other equity space. Investment style, risk tolerance, and overall fund objective are defined in virtually the same manner, although there is the added issue of deciding which markets to emphasize.
Because the nature of the asset class is particularly volatile, it's logical for an advisor to look for an emerging market offering that focuses on larger, more stable companies with broad exposure to a significant number of countries. One such fund we've found is Lazard Emerging Markets Equity Open. This fund relies on Lazard's large and globally diversified research team for its management, and in this case, both the emerging market equity and the emerging market fixed-income teams contribute to the effort. As a finishing check, each company is reviewed for potential political or corporate governance risks. The final portfolio is broadly diversified with 70 to 90 securities and exposure to all of the major emerging markets regions. Highly correlated to its benchmark, the fund provides good asset-class representation and has consistently provided investors with excess risk-adjusted returns. Just as consistently, it has been one of the least volatile emerging market offerings. Lazard offers an institutional share class of this fund for investors who can meet the higher minimums.
For advisors looking to implement an institutional grade asset allocation strategy, or those looking for additional diversification with more upside potential, exposure to the emerging markets space should be part of the plan.
J. Gibson Watson III is president and CEO of Denver-based Prima Capital (www.primacapital.com), a firm that conducts objective, institutional research and due diligence on SMAs, mutual funds, ETFs and alternatives.