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.
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