Tacticals

How To Build A Top-Down Factor-Based EM Strategy

Summary

  • We invest in the first quartile out of twelve emerging market countries.
  • Factors are chosen based on empirical evidence and academic findings.
  • This strategy outperformed the MSCI Emerging Index TR significantly.
  • Emerging countries worth investing now: Poland, South Korea and Brazil.

Market participants are increasingly aware of the inherent flaws of the most popular EM indices. They tend to allocate funds according to basic weighting schemes instead of identifying opportunities as they arise. To beat these benchmarks, portfolio managers must innovate and deviate from the index.

In this article, we discuss the investment process necessary to build the top-down factor-based strategy and we select emerging market countries worth investing. It is something new for us as our previous strategies are stocks only bottom-up oriented, but we are very satisfied with the results obtained.

Universe

First, we rank emerging countries by their adjusted by PPP GDP. Second, we go down that list and pick those meeting the five criteria of high-quality data: completeness, consistency, accuracy, validity, and timeliness. About twelve countries have all the time series necessary to build our strategy. We will eventually add more countries as data becomes available in the future.

Factors

We identified ten factors that may act as drivers of return for emerging countries. You will find each of them, how they are ranked, their short definition and importance in the table below. For those interested to see how each emerging country rank relative to others for each factor, these charts are available for free (this quarter only) to registered members of our website.

Ranking

The ranking system is a composite of these ten factors following a proprietary weighting scheme. The weighting is determined by assessing the importance of each factor by backtesting them individually against the MSCI Emerging Markets Index. We find that Inflation and Policy factors are by far the most important ones explaining future returns of emerging countries.

Simulation

We build a simulation that seeks to buy the best quartile of countries using the ranking system. The model is rebalanced quarterly and invest equally in the recommended countries. Our time series are available since 2006. We need at least one year to calculate most of the factors so we backtested the 2007 – 2017 period, which corresponds approximately to one business cycle.

Performance

The backtest result of our model portfolio strategy is quite promising. Since 2007, the strategy generated an annualized return of 15.4% vs 4.1% for the MSCI Emerging Markets Index Total Return. It outperformed the benchmark every year except in 2012 (it barely lagged). Finally, drawdowns are smaller during market downturns despite being concentrated in three ETFs.

 

 

 

Conclusion

Even if only three ETFs are held at any given time, each of them is made of many constituents which alleviate diversification concerns. Right now, the strategy recommends investing in Poland, South Korea, and Brazil. Because the outperformance has been consistent, we believe the odds are high that it may continue to generate alpha in the future although there is no guarantee.