Mutual funds that invest in emerging markets are infamous for their volatility, taking investors on roller-coaster rides that often leave them gasping.
Recently, however, a handful of fund companies, including
Fidelity Investments and
BlackRock Inc., have taken the wraps off emerging-markets funds that utilize strategies intended to lower the volatility of the portfolio. By using derivatives, investing in debt or short selling, these funds aim to give investors a less rocky emerging-markets experience.
“When we asked financial advisers what their best idea for the next 10 years was, they said emerging markets,” said Jeremy Chafkin, chief executive of Natixis Global Asset Management Group LLC's Alpha-Simplex Group LLC. “But they're only allocating 4% to 5% of portfolios to them because of the volatility. We wanted to provide a solution for that.”
Natixis launched its first low-volatility emerging-markets fund in October.
LOWER PERFORMANCE
But that solution may come at a cost, namely in the form of lower returns.
While it's too soon to draw any hard-and-fast conclusions, early indications suggest that the lower-volatility funds may significantly underperform traditional emerging-markets funds — at least when the category is on a roll.
Consider, for example, the BlackRock Emerging Markets Long/Short Investors Fund (BLSAX). The fund, which also was launched in October and has $58 million in assets, has an annualized standard deviation of just 3, compared with 27 for the average traditional emerging-markets fund. Since its launch, the fund has gained 3.7%, compared with a 20% gain for the Vanguard MSCI Emerging Markets ETF (VWO).
The Natixis ASG Growth Markets Fund (AGMAX) has had a similar story. Since its launch, the fund has gained 3.1%, compared with 12% for the average emerging-markets fund. The $26 million fund has a standard deviation of 9.7.
“We may have some short-term underperformance, but over the long term, it should lead to a lot more attractive Sharpe ratio,” said Mr. Chafkin, referring to the measurement of how much extra return an investment delivers for each unit of risk it takes.
Other fund companies that now run low-volatility ETFs include Dreyfus Corp. and
AllianceBernstein LP.
Emerging-markets funds have been the most popular stock fund category over the past 12 months, taking in approximately $22 billion, as investors see developing nations, with their growing middle classes, as having better growth potential than developed markets.
Despite the billions of dollars that are flowing into the funds, they remain susceptible to quick rises and falls. The MSCI Emerging Markets Index, the most popular benchmark for emerging-markets mutual funds, has a standard deviation of 25, more than 50% higher than that of the S&P 500, for example.
“The underlying volatility of the emerging markets is a particular problem that's difficult to address,” said Oliver Pursche, president of Gary Goldberg Financial Services, an investment advisory firm. “We try to tell clients we're looking at a long-term thematic approach to emerging markets, and we're not worried about a 10% or 15% swing. Generally, you see a little bit more of the whites of their eyes when you tell them that.”
A lot of the volatility is due more to outside factors than the emerging markets themselves, said Jason Ware, a senior research analyst at Albion Financial Group, an advisory firm.
“At the first sign of trouble, emerging markets are the first thing people flee,” he said.
It's especially true in the “risk on, risk off” environment the market has been in lately, said Nadia Papagiannis, an alternatives analyst at Morningstar Inc.
“Investors are judging whole asset classes and whole markets at the same time,” she added.
For example, last year, as fears over the U.S. debt ceiling and the sovereign crisis in Europe spread, emerging-markets stocks plummeted. The average emerging-markets fund lost about 20% in 2011.
Year-to-date through last Tuesday, the average fund was up 15%, according to Morningstar.
NO END IN SIGHT
There are reasons to believe the volatility will continue this year.
The situation in Europe is still not resolved, the U.S. elections are sure to have an impact on the markets and there are around a dozen elections in the emerging markets that could stir up some short-term volatility.
Those factors have some advisers interested in investing in the low-volatility funds. “We're very much in favor of a [low-volatility] strategy for the majority of our clients,” said Mr. Pursche.
Others, however, remain skeptical.
“On paper, it sounds great,” said Mr. Ware. “But do they actually work the way they're sold?”
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“On paper it sounds great. But do they actually work the way they're sold?”
Jason Ware
Senior research analyst
Albion Financial Group
