How To Build A Top-Down Factor-Based Emerging Markets Strategy

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Includes: EIDO, EIS, EPOL, ESR, EWW, EWY, EWZ, EZA, FXI, INDA, RSX, TUR
by: Francois Soto, CFA

Summary

We invest in the first quartile out of twelve emerging market countries.

Factors are chosen based on empirical evidence and academic findings.

This strategy outperformed the MSCI Emerging Index TR significantly.

EM countries worth investing in now: Poland, South Korea and Brazil.

Introduction

Market participants are increasingly aware of the inherent flaws of the most popular EM indices. They tend to allocate funds according to basic weighting schemes instead of identifying opportunities as they arise. To beat these benchmarks, portfolio managers must innovate and deviate from the index.

In this article, we discuss the investment process necessary to build the top-down factor-based strategy and we select emerging market countries worth investing. It is something new for us as our previous strategies are stocks only bottom-up oriented, but we are very satisfied with the results obtained.

Universe

First, we rank emerging countries by their adjusted by PPP GDP. Second, we go down that list and pick those meeting the five criteria of high-quality data: completeness, consistency, accuracy, validity, and timeliness. About twelve countries have all the time series necessary to build our strategy. We will eventually add more countries as data becomes available in the future.

Factors

We identified ten factors that may act as drivers of return for emerging countries. You will find each of them, how they are ranked, their short definition and importance in the table below. For those interested to see how each emerging country ranks relative to others for each factor, we made macro charts (as of Q3 2017) available at the end of this article in the appendix section.

Ranking

The ranking system is a composite of these ten factors following a proprietary weighting scheme. The weighting is determined by assessing the importance of each factor by backtesting them individually against the MSCI Emerging Markets Index. We find that Inflation and Policy factors are by far the most important ones explaining future returns of emerging countries.

Simulation

We build a simulation that seeks to buy the best quartile of emerging countries (three out of our universe) using this ranking system. The model invests equally in the recommended countries and is rebalanced quarterly.

This means all emerging country values must be updated and reassessed again on a relative basis at such frequency with the defined ranking system. Rebalancing only occurs if there is any material change in the first quartile.

Our time series are available since 2006. We need at least one year to calculate most of the factors. For this reason, we backtested the 2007 - 2017 period, which corresponds approximately to one business cycle.

Portfolio

The backtest result of our strategy is quite promising as seen above. Since 2007, the strategy generated an annualized return of 15.4% vs 4.1% for the MSCI Emerging Markets Index Total Return. Drawdowns are smaller during market downturns despite the concentrated position in three ETFs. Right now, the strategy recommends investing in Poland, South Korea, and Brazil:

Poland (EPOL)

The strategy is invested in Poland mainly because of the country's high momentum and low inflation relative to other emerging countries. However, the strong economic growth may revive inflationary pressures in 2018.

South Korea (EWY)

The strategy is invested in South Korea mainly because of the country's low inflation and low valuation relative to other emerging countries. However, tensions with North Korea explains why it is trading at a discount.

Brazil (EWZ)

The strategy is invested in Brazil mainly because of the country's high momentum and dovish policy relative to other emerging countries. However, sluggish economic growth and corruption scandals are risks to consider.

Conclusion

Even if only three ETFs are held at any given time, each of them is made of many constituents which alleviate diversification concerns. Because the outperformance has been consistent, we believe the odds are high that it may continue to generate alpha in the future although there is no guarantee.

Appendix

EM_Indicators_2017Q3.pdf

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.

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