Asking the right questions about Emerging Markets exposure – implementation matters

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Finding the right way to manage your exposure to an asset class is not a one size fits all proposition.

In my role as a Senior Portfolio Manager in Equity Derivatives, I work closely with transition, overlay, and other portfolio managers to find the most effective way for clients of different sizes and with different objectives to gain access to various types of market exposure. However, it is important to go beyond simply asking “what is the benchmark?” Knowing the answers is the end goal, but knowing which questions to ask is equally important in ensuring no part of the implementation strategy goes overlooked for our investors.

Emerging market equities (EM) are a classic example of this. EM has become part of the investment mainstream; nonetheless, getting the right EM exposure, at the right cost, can still be a challenge for investors. Those with developed market portfolios may wish to add EM exposure tactically at low cost; those with overweight EM exposures across their portfolios often want to moderate their EM exposure with a short derivatives position. Given the restrictive local regulations, higher transaction costs and greater volatility that are associated with this asset class, skilful and efficient implementation of your EM exposure is essential. In the following example we review different approaches, in this instance focusing on passive management solutions.

In a recent Strategy Spotlight, my colleagues and I highlight a range of possible approaches to accessing EM exposure at low cost and without buying an underlying portfolio of securities. The gap between highest and lowest holding cost approaches over 50 basis points per year – but that’s just the beginning of the story. In order to get the EM exposure you want at the lowest cost, you need to address a very wide range of criteria–in other words, you need to ask the right questions to arrive at the right solution. For instance:

  • Tracking error: how precisely do you need to match a particular index return?
  • Currency exposure: Do you want the currency exposure of the benchmark or do you prefer to have that exposure hedged to your base currency?
  • Flexibility: how frequently do you need to modify the size of your EM exposure?
  • OTC: are you able to trade over-the-counter instruments such as total return swaps?
  • Timeliness: is it important for you to be able to trade during local EM hours?
  • Funding: do you have readily available cash to commit to this exposure or do you need to achieve it synthetically?

These criteria will help guide you to the most appropriate outcome at lowest cost, according to your particular circumstances. Even so, navigating the trade-offs between these criteria requires expert insight and knowledge and can often vary depending on market conditions. That’s where a professional overlay manager can add value and help you identify the optimal solution that best suits your needs. And so the very first question is, do you need expert help to make the right trade?

Regan Babst, Senior Portfolio Manager, Equity Derivatives

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