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Strategies for taking on emerging-market exposure

Investors should take a studied approach, looking for geographical diversity and employing currency hedging

By: DAVID ISRAELSON

Date: April 5, 2016

Despite the tenuous global economic picture, investors should not ignore emerging markets, some advisers suggest.

But they recommend a studied approach that takes into account location, sector and risk-hedging strategies.

And it may require some patience.

“There are two dimensions,” says Todd Mattina, chief economist and strategist for Mackenzie Investments in Toronto. “One is the more tactical view over the next six to 12 months. The second is more strategic, related to your longer-run portfolio weight,” he says.

“If we focus on the tactical angle, the emerging markets space is really heading for what many call the perfect storm – lower prices for exports, tighter financial conditions and slower growth in main trading partners.”

It is worth looking at the bigger picture, Mr. Mattina says. “There are quite a few macro headwinds. For that reason we’re actually underweight [in our portfolios] in emerging markets right now.”

Some investors may see the plunging prices that have characterized the first quarter of 2016 so far as an opportunity. But it’s not clear whether emerging markets have hit bottom just yet, Mr. Mattina says.

“Even though emerging markets are getting more attractive after the recent selloff, in our view they’re still not attractive enough to outweigh the highly negative market sentiment around them.”

In January, the International Monetary Fund’s World Economic Outlook noted that in 2015, “Growth in emerging market and developing economies – while still accounting for over 70 per cent of global growth – declined for the fifth consecutive year.”

A month earlier, the Financial Times of London reported that 21 of 22 big emerging markets tracked by JPMorgan Chase & Co. had their consensus 2016 economic growth forecasts downgraded in the previous three months.

The worldwide oversupply of oil and other commodities and consistently weakening demand from China are major factors dampening emerging markets.

Nevertheless, investors should still consider maintaining positions in emerging markets, says Toronto-based financial author Sandra Foster, president of Headspring Consulting Inc. “Emerging markets can be thought of like the seasoning to a portfolio. A little might be just right. Too much could spoil it,” she says.

Experts cite tactical steps that investors can take to hold positions in global and emerging markets while tempering the risk that this involves. The first step is to understand what you are buying, Mr. Mattina says.

“Emerging markets are not a homogeneous group. You have commodity exporters, commodity importers, Asian emerging markets, Latin American ones. They all differ quite substantially,” he explains. “In this type of market environment you would want to differentiate between them.”

Ms. Foster says “it’s important to understand the country [where the emerging market is], its potential, its risks, and to limit one’s exposure.”

One way to limit exposure is through various hedging strategies. If investors are worried that the loonie will keep falling, they can buy into foreign markets in foreign currencies.

Investors can hedge by purchasing forward contracts that lock in today’s rates if they think these will deteriorate. Another hedge strategy is to set an option, agreeing on a rate that can be bought later at today’s rates.

Mr. Mattina says his company looks at the merits of emerging-market investment products, “then we make decisions separately on the currencies we want to have in our portfolio.

“A good way to think about it is: What is the desirable level of exposure for a particular currency? For example, the Japanese yen often tends to strengthen when global equities are under pressure, so the yen might provide some hedging,” he says.

Right now, his company feels that the yen is undervalued, while the British pound “is one of the most overvalued currencies,” he says. “We have been bearish on the Canadian dollar since 2014 and that has served us well,” he adds.

While there’s still potential for the loonie to drop more in 2016, eventually it should rise and settle at around 82 cents (U.S.), Mr. Mattina says. Though the question is how long that might take.

Justin Bender, portfolio manager at PWL Capital Inc. in Toronto, takes a different approach. “We tend not to use hedging for our foreign exposure,” he says.

“For our foreign equity exposure, we generally split it among the United States, developed countries outside North America and emerging markets.” They buy broad-based exchange-traded funds and try to limit their emerging-market exposure to about 10 per cent of portfolios.

Investors can also look to emerging market fixed-income investments, but the prospects don’t look great so far this year. JPMorgan estimates that returns on emerging market government and corporate debt are likely to be 1 to 3 per cent in 2016.

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