Geopolitical tensions often dominate the news cycle. On any given day in recent months, you are likely to read or hear about trade negotiations between the U.S. and China, Brexit, developing nuclear powers in Iran and North Korea, or increasingly strained relationships between Russia and the West. The question is should investors care?
Or, more importantly, should investors act on these headlines? These events undoubtedly influence investor returns, but perhaps not in the way you may think.
When portfolio managers invest in assets outside of a single country, they often start at the security level, seeking those securities that they estimate have the best chance to outperform indexes and peers in the future. While this is indeed a very important part of the process, there is another important part of investment selection — the country in which portfolio managers choose to invest. Headlines like the ones above — along with economic conditions, elections and long-term demographics, among many other factors — influence the prices of securities in a given country.
To demonstrate the volatility related to country allocations, we analyzed country returns based on the constituents of the MSCI EM and MSCI ACWI ex US indexes and evaluated the returns of high and low performers over an 18-year period.
The results in Exhibit 1 showcase the return spreads between high and low returners are substantial. There are other interesting observations to consider:
Historical annual country return spreads within emerging markets have been 80 to 88% larger relative to developed markets, putting greater emphasis on country allocations in emerging markets.
After removing the largest return outlier in emerging markets, annual country return spreads in emerging markets remained 40 to 60% larger relative to developed markets.
Return dispersions between high and low performers within EM relative to DM is persistent over time, indicating there likely is nothing unique about recent geopolitical events despite being seemingly more frequent today than they have been in the past.
Given the material influence country allocations have on return, is there opportunity to add value through country selection? To test this idea, we evaluated all emerging markets managers with a 10-year track record and found their “skill” in selecting countries was quite low.
Of the 87 portfolios, only 22% added value from country selection in a majority of quarters during the 10-year period. Just as importantly, none of the managers added value consistently throughout the period.
One partial explanation for the lack of success is that country returns, on both a relative and absolute basis, are random and very volatile, illustrated in Exhibit 2. This makes it difficult for portfolio managers to accurately predict which countries are poised to outperform year over year.
For example, no single top performer held the top spot the following year. Moreover, the majority of the time the top performing country fell to the bottom half in the following year. That said, top quartile emerging markets managers consistently outperform the benchmark over rolling three-year periods. With such lack of success in country selection, where is this outperformance derived from?
We believe key elements include security selection and risk management. A process focused on managing country volatility is far more likely to add to successful outcomes relative to an approach that derives country allocations from stock selection.
Do you have questions about your portfolio? Contact an advisor at Fi3 today.