A systematic approach to investing in emerging markets

There is a prevailing assumption that algo-driven systematic investment strategies are largely confined to developed markets, where depth and volume allow a wide range of assets to be traded efficiently and swiftly. On the other hand, conventional thinking says emerging markets are best addressed via a discretionary or fundamental investment approach, aiming to profit from a mix of political change, multi-lateral rescue financing, major shifts in commodity prices or post significant devaluations.

However, this demarcation is rapidly being challenged by the growth in systematic trading strategies within emerging markets. These trading systems have been able to prosper because emerging local markets have significantly expanded and deepened in recent decades.

One can now categorise there are over 25 investible emerging markets, being defined as developing nations wholly engaged with the global economy. Additionally, there are 22 frontier markets that have started to engage with global capital and have joined the investible universe. Although these frontier countries are lower down the scale in terms of economic size, market liquidity and accessibility, they now offer a new stream of potential returns. Therefore, with close to 50 independent countries and respective markets, investors can access far more diversity than developed markets, which seem to trade with increasing correlation and homogeneity.

Not only has the number of emerging markets countries increased dramatically, but so too has the number of accessible assets. Depending on the country; currency, commodities, and locally denominated debt have joined shares and sovereign bonds as tradeable instruments.  This is an important development for potential investors to consider given that EM indices, which focus specifically on either equities or sovereign debt, by their construction have a weighted bias to certain countries, and do not represent the full investible spectrum of instruments and countries. Indeed, by design these indices preclude the investor from taking bearish views on individual countries and can lead to lower quality returns.

The MSCI Emerging Markets Index is one of the most widely followed EM benchmarks but suffers from significant drawbacks in that it is exclusively equity-focused, and many consider it is overweight China. An index reflecting multi-asset, long-short EM investment for the same period, would likely be strongly positive, but no such metric exists.

A Modern Solution

For most investors making appropriate selections either between emerging economies such as India, China, Brazil, and South Africa, or frontier economies, such as Egypt, Nigeria, Zambia, Kazakhstan and Vietnam, is largely about risk tolerance, the ability to assimilate so many country specific variables and lastly, viability of access.

This is where a systematic approach is proving invaluable, in my opinion. Firstly, these proprietary algorithms are designed to exploit small, often shorter-duration opportunities which abound in less efficient emerging markets.  It has become fertile territory, in particular for hedge funds, who are able to invest in both long and short positions, effectively capturing dispersion, and reducing market risk.

Secondly, a system is adept at organising, discovering and standardising data as well as being able to dynamically adjust numerous positions for changes in signals and volatility. What has become increasingly complex for the discretionary manager, is now becoming routine for the systematic manager.

Finally, because an algorithmic system aspires to trade as many instruments as possible, the investment manager is incentivised to build as many bridges into local markets as possible.

In the larger emerging markets, these choices stretch from commodities priced in Renminbi, to Qatari equity swaps and to locally denominated South American government bonds. However, cost effective access to these onshore markets usually require an investor to have locally based custodians and bi-lateral trading and clearing relationships.

For the smaller frontier markets, there are products as diverse as Zambian 5-year local bonds, Egyptian 12-month T-Bills or Vietnamese equity swaps, but access can only be facilitated by investment banks providing synthetic exposure to the underlying assets.  Currently, investment banks are offering this access only to specialist investors.

Conclusion

Today, emerging markets are front-page news due to the Russian invasion of Ukraine. However, in the middle and on the back pages, emerging and frontier markets are becoming ever more diverse and offering uncorrelated positive returns, despite rising global interest rates. As ever, capturing these returns is part process, part skill and part access and a systematic approach might be one of the answers.