Monday, April 23, 2007

Beta investing in EM

It’s been a fairly dull start to the morning, with equities slightly lower, bonds slightly higher, and EUR/JPY down about half a percent. News headlines include an S&P upgrade to Japan’s long-term local currency rating (AA- to AA), and two stories that were subsequently denied:

* The FT carries a story that Japan is mulling the establishment of a sovereign wealth fund, a story that percolates every so often. While the MOF denied it, such a fund seems inevitable, given the state of the country’s demographics. Such a fund would almost certainly have negative consequences for the dollar, given that a high proportion of Japan’s reserves are kept in the greenback.

* Bank of Greece governor Garganas was quoted in a newspaper story as stating that further euro strength may preclude additional tightening from the ECB. This was partially responsible for the early stop loss run in EUR/USD and EUR/JPY. No doubt after an angry phone call from M. Trichet, the Bank of Greece subsequently denied the comments. It’s unlikely that the French elections have had much impact, though the outcome (Sarkozy and Royal making it past the first round) may increase the chance of the odd moan about euro strength over the next couple of weeks.

There was an interesting post in All About Alpha the other day linking to a Bridgewater piece on hedge fund beta masquerading as alpha. This calls to mind Macro Man’s recently-dormant research agenda on beta strategies. Remarkably, it didn’t take long to come up with a reasonable proxy for emerging market exposure that matches the Tremont emerging index, net of fees.

Per the Bridgewater note, emerging market returns can be thought of as ½ equity and ½ fixed income. Even within the fixed income space, currency and carry explain most of the returns. So a simple strategy of ½ EM equities and ½ EM carry basket would appear to capture the flavour of EM investing. Could it really be that simple?

As it turns out, it can. Macro Man constructed a simple index of ½ MSCI Emerging equities, ½ a carry basket of popular EM currencies plus the G3. While there is undoubtedly some ex-post selection bias here- THB is not included in the carry basket because it is fairly unfeasible to trade it offshore in size at the moment- the basket does capture most of the EM currencies that have been popular to trade over the past fifteen years.

He calculated returns on both a gross and net of performance fee (20%) basis. While he did not include a management fee in his calculation, by the same token he also did not include any return on cash deposits, either. The results are set out in the chart below.

The correlation of monthly returns is a fairly impressive 0.69, with comparable Sharpe ratios for the post-fee replication and the CSFB index. The pre-fee replication clearly enjoys a superior Sharpe. Returns over the past five years have been particularly strong in the asset class, as BRIC-mania has gripped stocks, bonds, and currencies. While past performance is clearly no guarantee of future returns, it would appear that Macro Man would do well to include EM assets in his beta portfolio.

The question is whether he can tweak the replication with a market-time element to turn it from a pure beta play to a beta-plus. A bit more research is required here. While there are undoubtedly superstar EM managers who trounce the index on a regular basis, it would appear quite clear that one can capture the bulk of the asset class’s returns with relatively little effort and at a cost substantially lower than two and twenty.


Anonymous said...

MM ,

I am a novice learning from this blog. Could you pls advise on the terminologies "alpha" and "beta" mean your post.

Any weblink which explains the same would do fine as well.

When searched on web, i got confusing results :-(


Macro Man said...

In simplistic terms, the term beta refers to that portion of a fund manager's returns that reflect the performance of the broad market (whatever market a particular fud manager may invest in), while alpha refers to that portion of a manager's returns that are down to the manager's skill in security selection.

On an individual stock or security basis, beta refers to that portion of the stock's return that can be attributed to overall market peformance, and that portion that represents the merits or demerits of the company.

The point of my exercise (and indeed of the All About Alpha post) is that a lot of what purports to be manager skill can actually be identified as participation in broad market performance.

Or, looking at it another way, one can get exposure to an asset class via a simple replication strategy that will capture the majority of the asset class's returns without incurring heavy fees.

Anonymous said...

For much of the 90s and til say 2005, a lot of EM hedge funds were making bets on the credit spread of EM $ bonds (getting argentina right -- by getting out in 00 -- and getting brazil right -- by getting in in 02/03 -- drove a lot of returns). So on the fixed income side, it hasn't been all about carry and currency risk. The correlation between currency risk and credit risk for most EM sovereigns has been pretty high (something that all the folks who now short the $ debt via the CDS market to provide a cheap proxy "hedge" for their local currency exposure now exploit), which means that the carry bit may be picking up a fair amount of the credit spread compression/ widening.

nonetheless, until fairly recently, most fixed income exposure was, i think, through dollar and euro debt. this has changed big time, but it is a fairly recent shift.

brad setser

Macro Man said...

Very good point, Brad. This analysis completely ignores external debt. Yet, as you say, there has traditionally been a high degree of correlation among various EM assets.

If anything, the bulk of underperformance of my naive strategy versus the broader index appears to have been in the mid 90's...which may be explained by the relative performance of Bradys versus local currency debta and equities. Still, a 0.69 return correlation ain't bad for something that didn't take that long to come up with!

Anonymous said...

Ref EMEA currency basket ...can I kindly ask what was the composition ??? cheers ..

CV said...

Interesting post Macro Man ...

On the Japanese wealth fund. I completely agree that this is in part a result of the Japanese demographic fundamentals. All those assets are going for yield now.

In terms of the dollar implications. I hardly think anyone can argue that you are right but what about official policies on the markup of the portfolio? I mean how much are we going to see these funds (e.g. from official governmental institutions) go into assets such as equity (for example) if it is not only on the margins?

This I guess is the same issue with China is not although of course they are pegging.

Macro Man said...

CV, I tend to take the rumours coming out of China at face value- namely, that they will be investing in equities over time.

Let's face it- if they weren;t going to, what would be the point of taking the reserves away from SAFE? In this regard, I suspect they will allocate a higher weight towards EM/regional equities than would be implied by MSCI World weightings- certainly GIC in Singapore has done so.

Norway is perhaps instructive (though obviously much further down the development curve)- they've recently announced an intention to raise the equity weight in the $300 billion petroleum fund from 40% to 60%.

(As an aside, if China decides to centralize its [currently nonexistent] pension assets into one fund....holy cow, will it be big.)