Investors are increasingly using passive portfolios to boost exposure to emerging markets and keep volatility under control. We see better ways to reduce the risks while sourcing returns from across the developing world.

Emerging stocks and bonds have strongly outperformed this year, as return-starved investors fled the bleaker prospects on offer in developed markets. Flows are also showing signs of life. Brightening EM economic conditions, rebounding earnings growth and attractive valuations suggest that the EM equity rally has more room to run.

In developing markets, however, greater opportunity comes with greater risks. Though volatility across global stock markets has diminished since 2012, the EM equity market is nearly six percentage points more erratic than its developed counterpart (Display). It’s critical to stay attentive to risks that could derail performance.

The Passive Slippery Slope

[drizzle]Investors manage EM volatility in several ways. Many of them have gone the passive route. Investor interest in low-volatility strategies reached a fever pitch earlier this year. Flows into the dominant low-volatility EM exchange-traded fund (ETF) surged nearly 70% to US$4.4 billion through September, twice the pickup of flows into the MSCI Emerging Markets ETF for the same period.

But, by tethering themselves to a low-volatility index, investors are also tethering themselves to risky concentrations in certain pricey sectors. Telecom, consumer staples and utilities stocks have massively outperformed for the past several years as investors gravitated to bond proxies offering stable earnings and high dividends. These stocks now make up one-third of the MSCI EM Minimum Volatility Index, or double their share of the MSCI EM Index, and trade at some of their highest valuations of the past 20 years (Display). They are also highly interest-rate sensitive. Because low-volatility indexes are constructed largely based on historical patterns, they can’t adapt when conditions diverge from the past. This may leave passive investors especially vulnerable to a major about-face in rates, risk sentiment or the macro climate.

Indeed, we’ve seen these vulnerabilities play out in the painful unwinding of low-volatility strategies and so-called “safe haven” stocks that began in August amid a sharp turn in risk appetites. The crowding appears to have amplified the sell-off.

It’s also important to remember that while passive approaches provide a low-cost way to fully benefit from market rallies, they do nothing to protect against downturns, which can have a corrosive effect on performance over time.

Better to Make Distinctions

To capture the rich EM equity potential with less volatility, we think a high-conviction selective approach is the way to go. The stresses facing emerging economics are myriad: China’s economic transition, slowing global trade, mounting debt levels and the eventual tightening in US monetary policy will impact different countries in different ways. A one-size-fits-all perspective won’t work.

Active strategies can apply local and global perspectives to find tomorrow’s winners and avoid pitfalls. In these stress-prone economies, defense counts more than offense. A big part of playing defense is staying watchful of looming country-specific risks. For example, we tend to find economic insights into individual developing nations more useful for avoiding losses than for selecting stocks with return potential.

For equity-only investors, our research shows that actively focusing on the fundamental sources of quality and stability (that is, high and sustainable profitability)—while avoiding overpaying—can generate higher and more consistent returns than a mechanical focus on low volatility alone.

For investors able to broaden their horizons beyond equities, a multi-asset approach that makes active trade-offs between EM stocks, bonds and currencies can also produce attractive risk-adjusted returns by tapping the broadest opportunity set. In a simplistic illustration, over the past 10 years, a 60% EM equity/40% EM bond portfolio has been 30% less volatile than an all–EM equity portfolio (16.9% versus 23.5%).

In EM investing, the secret to success is to hold on to as much of your gains as possible over full market cycles. In our view, a smoother-ride approach—whether within an equity-only or a multi-asset portfolio— that is preemptive in identifying sources of both return and excess volatility has a better shot of delivering desired investment outcomes.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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