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.

Emerging Market

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.

Emerging Market

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.