"In the short run, a market is a voting machine, but in the long-term, it is a weighing machine." -Benjamin Graham
Most investors try to avoid the word "volatility" as it is associated with potential monetary losses. Nevertheless, high volatility also means potential gains. Commonly, the greater risks lead to the higher returns.
Investors are risk-averse and are trying to avoid potential losses at any cost. Behavioral finance studies the behavior of investors, who tend to act irrationally by buying at too high and selling at too low. Kahneman & Tversky's study showed that the pain of losing is psychologically twice as powerful as the pleasure of gaining.
Since the beginning of the year, investors have been enjoying the higher returns on emerging markets equity that outperformed S&P 500 Index.
As an example, before the US elections FTSE Emerging Markets ETF (TICKER: VWO), the largest equity emerging markets ETF, was beating S&P 500 Index (Ticker: SPX) by 14.06% and iShares MSCI Emerging Markets ETF (TICKER: EEM), the second-largest equity emerging markets ETF, was beating S&P 500 Index (Ticker: SPX) by 12.36%.
The pattern had changed dramatically since the elections when the performance of both funds dropped significantly.
"It requires a strength of character to think and to act in opposite fashion from the crowd and also patience to wait for opportunities that may be spaced years apart." - Benjamin Graham
For the last year, emerging markets have had spikes in volatility, including at the beginning of the year, June, September, and November.
For the last year, iShares MSCI Emerging Markets ETF was trading above 50- and 200-day average since April.
- The largest sell-off of the fund shares happened at the beginning of the year when markets were unpleasantly surprised by Chinese economic data and the slowdown of the economy. The price dropped from $33.19 to $28.25.
- The decision of Great Britain to leave European Union triggered another sell-off of emerging markets securities that led to the price falling from $34.76 to $32.23.
- After the unexpected victory of Donald Trump in presidential elections, iShares MSCI Emerging Markets ETF share price dropped from $37.08 to $34.30 due to the $1.5 bn of withdrawals (5% of the NAV), the largest since 2011.
- The fund invested in 26.91% of NAV in Chinese and 3.38% of NAV in Mexican equities, which are expected to suffer the most due to the expected tariffs.
What triggers panic on the markets and global sell-offs?
- Besides of the uncertainty over Donald Trump's protectionist policy, investors expect increased fiscal spending on the infrastructure and interest rates, and a stronger dollar that will make domestic investments more attractive.
- Markets expect that interest rates will hike this December. The last interest rate hike of 0.25% led to the massive selloff of the emerging markets securities, which is reasonable to expect after the Federal Reserve increases interest rates.
- Therefore, a high degree of volatility in the emerging markets can be expected for the next few months due to the expectations of the interest rate increase and overall policy of a new president.
"The intelligent investor is a realist who sells to optimists and buys from pessimists." -Benjamin Graham
How can an investor take advantage of the volatility?
Most investors had seen a movie "The Big Short" or read the book by Michael Lewis and know how players benefited from the real estate market collapse. A short position always wins when the price of the asset declines and especially when there is a panic on the market.
The fund is taking the opposite position of the MSCI Emerging Markets Index (Ticker:MXEF), and investors lose money when the Index goes up and gain money when the Index goes down.
Since the beginning of the year, emerging markets have been performing well, which has led to the poor performance of ProShares Short MSCI Emerging Markets ETF.
Nevertheless, with the coming November elections, emerging markets became volatile, and ProShares Short MSCI Emerging Markets ETF started to perform very well. The election boosted the performance of the fund up to 77.20%.
Source: Bloomberg Terminal
Who might be interested in such a game of volatility?
- Risk takers
Those who want to bet against the emerging markets based on the increased uncertainty over international politics. Donald Trump will take his place in the office on January 20th, and for the next 100 days increased volatility can be expected. A single position may lead either to high returns or significant losses.
Investors who have a position in emerging markets and don't want to sell equity for an unfavorable price can take the opposite position and decrease the overall risk of the portfolio.
The maximum hedging effect occurs when the correlation is close to perfectly negative, meaning that the assets move in different directions.
I have created a correlation matrix for the last two years that provides meaningful insights. Based on the matrix ProShares Short MSCI Emerging Markets ETF is the perfect instrument to hedge large well-diversified funds, such as FTSE Emerging Markets ETF and iShares MSCI Emerging Markets ETF.
A position in iShares MSCI Emerging Markets ETF or FTSE Emerging Markets ETF and ProShares Short MSCI Emerging Markets ETF will limit the potential losses compared to any standalone position.
Investors can overweight any position based on their market view and current market conditions, individual risk tolerance and return objectives.
Position in ProShares Short MSCI Emerging Markets ETF is a useful instrument for the hedging S&P 500 Index.
China and Mexico are the main trade partners of the USA and expected tariffs would hurt both economies in unexpected ways, potentially even causing a recession.
The bottom line
- Most investors view volatility as a sign of potential losses that leads to psychological pain.
- Investors are loss-averse, and tend to panic and sell their positions at the wrong time when the price is low.
- Taking the opposite position allows investors to bet against the markets and if the bet is successful, gain a high return.
- The opposite position allows hedging the adverse effects of the market movements, minimizing losses and decreasing the overall risk.
- Investment in ProShares Short MSCI Emerging Markets ETF is an excellent opportunity to take extra risk in the markets or hedge the existing positions.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.