Emerging Markets: An Active Trading Strategy

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Summary

MSCI Emerging Markets Index (Ticker: MXEF) had an outstanding performance for the last year, outperforming the S&P 500 Index.

Adding emerging market securities to the portfolio allows for hedging developed markets and receiving additional returns.

Active strategy is designed for sophisticated investors who actively trade with ETFs.

The approach is based on the combination of the long and short position in swap-based leveraged ETFs.

While the long position allows focusing on the long-term horizon, the short position allows for achieving short-term returns and hedge portfolios.

For the last year, Emerging Markets had an outstanding performance relative to developed markets. Nevertheless, from expectations driven by S&P 500 Index (Ticker: SPX) and Dow Jones Index (Ticker: INDU) returns, MSCI Emerging Markets Index (Ticker: MXEF) outperformed S&P 500 Index by 1.13% but underperformed the Dow Jones Index by 3.18%.

Source: Bloomberg Terminal

  • MSCI Emerging Markets Index is a free float-adjusted market capitalization index that originated to measure the equity market performance of emerging markets. The index consists of 23 countries, the largest of which are: China (26.52%), South Korea (14.42%), Taiwan (12.2%), India (8.33%) and Brazil (7.69%).
  • The largest sectors of the index include: Financials (24.43%), Information Technology (23.26%), Consumer Discretionary (10.28%), Energy (7.88%), Materials (7.56%) and Consumer Staples (7.19%).
  • The Top 10 Holdings consist of: Samsung Electronics (3.75%), Tencent Holdings (3.53%), Taiwan Semiconductors (3.52%), Alibaba Holdings Group (2.50%), China Mobile (1.65%), China Construction (1.64%), Naspers (1.64%), Baidu ADR (1.13%), ICBC H (1.12%) and HON AI Precision Ind Corp (1.03%).

What are the advantages of investing in Emerging Market securities?

  • Strong fundamentals

Comparing MSCI Emerging Markets Index to the S&P 500 Index, MSCI Emerging Markets Index is more solid based on P/E, P/B, P/S ratios. MSCI Emerging Markets Index also has a higher dividend yield.

Source: Bloomberg Terminal

Source: Bloomberg Terminal

Currently, the main issue with the emerging market companies is decreasing profitability (Operating Margin, Profit Margin) ratios, which also translate to lower ROA and ROE. Indeed, the dividend payout ratio is increasing, meaning that companies are investing less; this may lead to slower growth in the future.

Source: Bloomberg Terminal

  • Diversification

The U.S. elections boosted the performance of the U.S. equity markets, which has consistently beat records. There are many opinions concerning whether the markets are accurate or overreacting in their expectations and if we should expect another bubble burst in the nearest future. The fact is that no one knows what will happen.

While overweighting US equity, a good idea is to have a small allocation in the emerging markets.

The historical correlation between Emerging and Developed Markets Indexes. Source: Bloomberg Terminal

  • Strong dollar hedging

In the last two months, the dollar has been getting stronger based on the recent interest rate hike and expectations of fiscal stimulus. As I have mentioned before, the dollar is following the same sentiment as equity markets and may change its pattern if the expectations don't realize.

Historically, emerging market currencies have a negative correlation with the dollar, which can be used as a hedging tool.

Bloomberg Spot Dollar Index (Ticker: BBDXY) and MSCI Emerging Markets Currency Index (Ticker: MXEFCOCX0). Source: Bloomberg Terminal

  • Recovering oil prices

OPEC and Russia's latest decision to cut oil production has increased the price of oil, which will support emerging market countries that depend on the oil exports, such as Russia, Mexico, and Brazil.

MSCI Emerging Markets Index (Ticker: MXEF) and IMF World Crude Oil Index (Ticker: 017843 Index). Source: Bloomberg Terminal

Nevertheless, there is a risk that the agreement will not be honored, as countries of OPEC tend to cheat. Previous agreements have shown that nations are able to break agreements since there is no enforcement mechanism in place.

The reason for the low oil price is excessive supply, which may be supported by increased demand in certain countries and lead to an oil price recovery in the next year or two.

What are the concerns about investing in the emerging markets?

  • Protectionist policy

Most of the emerging market countries depend on exports, and if Trump implements his protectionist policy a lot of these countries will experience downward pressure, especially China, South Korea, Brazil, and Mexico.

  • China is the largest country in the index and is the primary concern.

Since 2015 China's economy has been slowing down: GDP growth has decreased from 6.9% to 6.7% and is expected to decline to 6.1% by 2018.

Source: Bloomberg Terminal

As a result, the Chinese economy has experienced capital outflow that has led to a decrease in the index from $860 to $703.

Chinese Foreign Direct Investments (Ticker: CNNMFDI). Source: Bloomberg Terminal.

In the last year, the capital outflow has increased, which hasn't been driven solely by Trump's expected tariffs on Chinese import but also by the economic slowdown, the housing bubble, and significant corporate leverage.

In a recent Communist Party meeting, the President of China Xi Jinping lowered the GDP target rate from 6.5% to 6.1% due to the economy housing bubble and significant corporate leverage. The total debt increased to 246% of the GDP (165.06% corporate debt and 22.13% government debt).

Chinese corporate debt as a percentage of GDP (Ticker: CHBGDCOP) and Chinese external debt as a percentage of GDP (Ticker: GDOBCHIN). Source: Bloomberg Terminal.

The mentioned move can be considered a positive sign that the government will address the high leverage and speculative real estate market risks.

The increased capital outflow depreciated the Yuan, which fell from 6.92 to 6.55 (5.64%). The effort to support the national currency burned foreign exchange currency reserves. For the last year, reserves have decreased from $3.22 trillion to $3.05 trillion, which is the lowest it has been since February.

Source: Bloomberg Terminal.

If reserves fall below $3 trillion, increased volatility in trading Yuan can be expected. Investors are waiting for the next data release on 01/07/2016.

To fight capital outflow and support the government, the minimum reportable amount of Yuan on any cash transaction has been reduced from 200,000 to 50,000.

Nevertheless, due to the efforts to decrease capital outflows, further withdrawals and currency depreciation can be expected in the future.

Active trading strategy

Investors can't invest directly in the MSCI Emerging Markets Index index but can indirectly through ETFs.

Direxion Markets Bear 3X ETF (TICKER: EDZ) and Direxion Markets Bull 3X ETF (TICKER: EDC) are 3X leveraged ETFs, which implies a higher risk as a 1% change in the MSCI Emerging Markets Index would translate into a 3% gain or loss during the day but could be lower/higher after the day's rebalancing. Both funds are swap-based and require daily rebalancing, which implies a higher expense.

Investors can choose between a long position (Direxion Markets Bull 3X ETF) or a short position (Direxion Markets Bear 3X ETF) on the MSCI Emerging Markets Index. Both of the funds have superior liquidity, which is good for trading.

This strategy requires an appetite for risk, an understanding of the possible significant losses and a constant monitoring of all positions.

The challenge is to identify the direction of the index. One option is to combine long positions with a short position that has a higher spread in the expected direction of the index performance.

Source: Bloomberg Terminal.

To demonstrate the concept, I will take a possible trade with $1,000. Let's say an investor is bullish and purchases 12 shares of Direxion Markets Bull 3X ETF in June 2016 when the price is low for $48.64 (average price for June). At this time, it is not a good idea to buy Direxion Markets Bear 3X ETF because the price is too high.

In August the price of Direxion Markets Bear 3X ETF lowers and so the investor buys 17 shares for $24.87 (average price for August). As a result, $583.68 is invested in the long position and $422.79 in the short position.

Source: Bloomberg Terminal.

As a consequence of the correct timing of purchase and direction of the trade, returns are 20.69%.

Source: Bloomberg Terminal.

Trading is hard, and not every investor can "buy low and sell high."

To compare the ideal scenario, I will use another scenario in which the investor enters the market at the wrong time.

In September 2016, the investor purchases eight shares of Direxion Markets Bull 3X ETF for $64.13 (average price for September) and in October 2016 buys 21 shares of Direxion Markets Bear 3X ETF for $22.48 (average price for October). As a result, the return is only 0.88%.

Source: Bloomberg Terminal.

Source: Bloomberg Terminal.

Therefore, the role of active monitoring is crucial in this strategy. "Buy and hold" may work only if an investor gets the best price every time, which is not realistic.

The election results in the USA have increased volatility and capital outflows from emerging markets. Thus, the MSCI Emerging Markets Index has felt sharp and decided it was a good idea to use the short-term opportunity with Direxion Markets Bear 3X ETF.

The price of Direxion Markets Bear 3X ETF increased to $28.35 on November 14th, and an investor could have realized around 20% depending on the time of sale. The next phase is to keep a long position and wait until the price of Direxion Markets Bear 3X ETF lowers again to buy the needed amount of Direxion Markets Bear 3X ETF shares to hedge Direxion Markets Bull 3X ETF.

I believe that the emerging markets will recover in 2017, as they have a higher growth GDP than the developed countries and the government improved monetary and fiscal policies that will support the growth.

Nevertheless, a short-term increased volatility for China can be expected after Trump takes his post. The appointment of Peter Navarro, a known anti-Chinese alarmist who was appointed to lead the new presidential office in US trade and industrial policy, supports this assumption.

Thus, the increased probability of amplified short-term volatility in 2017 creates an opportunity to be long in emerging markets and use short term volatility to gain an extra return on a short-position.

Disclosure: I am/we are long EDC, EDZ.

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.

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