In a recent report Deutsche Bank discusses the implications from proxy-hedging in the Emerging Market (EM) asset space. They believe proxy-hedging among emerging market debt investors seems appropriate as they have to de-risk their portfolio holdings in-line with higher market volatility triggered by talks on QE tapering by the U.S. Federal Reserve. However, should rating agencies jump on the bandwagon by lowering their recommendations on sovereign debt among major emerging market countries, the worst is yet to come.
Proxy Hedging During Europe Crisis
Deutsche Bank AG (NYSE:DB) (ETR:DBK) noted that on August 12, 2011, a short-selling ban was introduced for Belgium, Spain, Italy and France to calm down equity markets, especially in the European periphery. Before this day, e.g. the Spanish (IBEX35), Italian (FTSE MIB) equity indices trended lower during H1 2011 end eventually sold-off when benchmark yields started to spike from July 2011onward (see below figure). Then the short-selling ban was implemented and these equity indices stabilized while all over sudden the German equity index (Dax30) sold-off dramatically without any changes fundamental-wise as (especially) the Dax future was used as a proxy-hedge to implement the “short-view” on Europe. The price decline in the Dax30 lasted for about 1 month until it stabilized again. This technical event offered one of the most obvious buying opportunities in the German equity index in the past 10-15 years.
Deutsche Bank AG (NYSE:DB) (ETR:DBK) reviewed this event as the use of proxy-hedges in the Emerging Markets (EM) asset space takes center stage again and has some interesting implications for equity/debt investors that are stuck with their highly illiquid positions.
Implications From Proxy-Hedging In Emerging Markets Today
Deutsche Bank AG (NYSE:DB) (ETR:DBK) highlighted that emerging market equity indices have been underperforming DM equity indices since mid-2011 on the back of fundamental weaknesses at the microeconomic level – an issue which they had been highlighting in many research reports across their Global Markets platform (“CROCI views”, “GEM strategy”, “European Equity Strategy – Consensus Earnings Trends”, etc). Fund flows into the emerging market region (both on the equity and the debt side) continued as global investors held on to the “consensus long emerging market story” up until Q4 2012 when the emerging market underperformance in the equity market was questioned for the first time on a broader scale.
Since then, emerging market equity funds witnessed mild outflows and the mega trend of strong inflows month after month since 2007 appeared to have come to an end. While emerging market equity funds started to see outflows from Q1 2013 onwards, the flow into emerging market debt funds continued until the U.S. Fed started talk on tapering of quantitative easing (QE) from 22nd May 2013 onward.
Since then, investors with exposure to emerging market debt started reducing their positions but where limited by the insufficient liquidity in the market. Consequently, they started to use MSCI emerging market equity ETFs as a proxy-hedge which triggered even stronger under-performance of the respective equity index vs. DM indices as well as stronger outflows from emerging market equity funds relative to the period from Q1 2013 until May 22nd 2013.
Deutsche Bank : Hedging EM Exposure With Lower Risk
As a result, equity investors who are exposed to emerging markets needed to de-risk their portfolios to some extent as well. Many investors continue to have emerging market mandates or a target EM allocation for their portfolios. Deutsche Bank believes that the MSCI Emerging Markets Minimum Volatility Index offers investors an opportunity to reduce their risk whilst maintaining emerging market exposure during a period when equity volatility in EM may stay elevated. Figure below shows the performance of MSCI Emerging Markets Index and MSCI Emerging Markets Minimum Volatility Index and underlines the lower risk attributes of MSCI EM Minimum Volatility compared to the parent market-cap weighted index.
The EM Min Vol index tends to be more defensive than the standard MSCI EM index and has a lower weighting in Chinese companies that have seen increased turbulence as of late. A sector comparison between the MSCI EM Min Vol and standard indices is shown in figure below.
Deutsche Bank AG (NYSE:DB) (ETR:DBK) believes that overall the minimum volatility portfolios may provide better risk adjusted returns than their usual market-cap weighted index equivalents and may outperform in environments when equities are declining. MSCI minimum volatility indices are constructed to be highly investable and replicable. Additionally, the MSCI minimum volatility methodology restricts deviations from the parent index’s sector and country allocation to +/-5%. Using this minimum volatility methodology results in a well-diversified portfolio expected to have lower downside volatility than the market cap-weighted parent index.