Emerging markets offer safe harbour

Emerging markets offer US funds significantly safer investment opportunities than some G7 countries, according to new research from risk analysis firm RiskMetrics.

The company’s RiskGrades measure the volatility rather than the returns of groups of assets and they show that German and UK assets are significantly more volatile than investments in such countries as China, Argentina and Egypt.

These findings could be especially useful for the small but growing number of fund managers that seek a particular level of risk in their investments – a process common with the sell side that is known as risk budgeting.

Figures are benchmarked to 100, which was the level applied to the entire MSCI universe when the measurements were created in 1998. RiskMetrics then breaks down the MSCI components by country to compare directly their volatility levels. The figures used here are created from the point of view of a US investor, so dollar foreign exchange volatility has an impact.

The higher an asset’s grade is over 100, the more volatile it is. If it is 25 points over that 100 level, 95% of the time the value of investments would fluctuate by no more than 5% over a given period. If it is 50 points higher, the fluctuation would be no more than 10%.

This is similar to a value-at-risk assessment, but it is standardized and weighted so that figures can be directly compared despite the different notional amounts of the assets. The grades can imply a volatility of over 100% because theoretically, speculators can take short positions in assets, exposing themselves to the possibility of heavy losses.

Grades of anxiety High grades reflect high levels of uncertainty and anxiety about a country’s economic future. Argentina, whose August 4 figure was 131.8, may not offer many obvious investment opportunities, but investors do appear to be reasonably confident that they can predict how those opportunities will develop.

In Germany, however, where the August 4 figure was 333.2, investors seem to be uncertain about the European Central Bank’s monetary policy and its effect on German assets. The US, which has a consistent monetary policy, offers little volatility, with an unusually low score of 79.1.

Around the same period, the grade of the Lehman bond index was around 125 and the S&P500 was about 175.

Regulatory pressures may at some point force portfolio managers to reveal the level of risk that they are comfortable with, rather than just the returns that their funds have generated.

Of course, developed markets offer a broader range of investment opportunities, whereas some emerging markets offer little possibility for diversification and less liquidity, but these figures do suggest that if investors are avoiding emerging markets because of an aversion to volatility, their efforts may be misplaced.

“As a rule most people think the same way about emerging markets as they did in 1994,” says Mike Thompson, who is one of the founders of RiskMetrics. “They think ‘they’re risky, they’re risky’. But when you look around, you see that developed countries often have greater risk. That has got to make a difference in where you are allocating your money.”