Emerging Market Debt: Perfect timing?
Peter Marber re-explores averaging strategies for entry into emerging markets
Emerging markets (EM) debt and equity have outperformed US and European equivalents since 2000. However, most institutions and individual investors remain conspicuously underweight these asset classes. Many investors say that they believe in these asset clases but often question whether it is the right time to invest. For those long-term believers who are worried about timing, ‘averaging-in' is an age-honoured approach of making periodic purchases to take advantage of market ups and downs. There are three variations that might help with the timing decision:
• Unit averaging (UA). Investors target a unit size of investment at pre-defined intervals (month, quarter, year, etc). When prices are higher, investors will pay more, when prices are lower, they'll pay less;
• Dollar-cost averaging (DCA). This approach requires the investor to invest the same amount of money each period, versus buying the same number of shares in UA. This way, DCA strives to better the arithmetic average price that UA generates (by forcing investors to buy more shares when price is low, and fewer when price is high), while providing investors a fixed cash-flow schedule for investment;
• Value-target averaging (VTA). Like UA and DCA, VTA (sometimes called ‘value averaging' or ‘value rebalancing') is a formula-based strategy. The underlying philosophy is to invest an amount of money so that the value of your holdings will meet a pre-determined target value in each period. The key difference from UA or DCA is that, in order to meet target value, VTA followers may actually need to sell some holdings. In volatile assets classes - like EMs - VTA would conceptually take better advantage of extreme price swings than DCA because of this selling mechanism. And VTA has been shown to produce higher investor internal rates of return (IRRs) than DCA, as well as other random timing strategies.
It is worth examining a volatile stock over seven observation periods. In figure 2, the stock starts at a $95 share price that drops to $92, then $91, $88, crashes to $81, then skyrockets to $108, falling down to $94, then finishing up at $103. We'll examine it in reverse sequence as well. For UA, we target $10,000 worth of stock initially trading at $95 - or 105.26 shares, the static number of shares we'll invest each period. For DCA, $10,000 will be our anchored periodic investment amount, and for VTA $10,000 will be our periodic target value increase.
In this example, UA average cost is $94 per share. With DCA, the average is $93.35 - a small but important improvement. However, VTA's base cost per share is $88.98, or $5.02 cheaper than UA and $4.37 less than DCA. In the down sequence, VTA produces a $91.78 cost versus UA's $94 and DCA's $93.35. In both up and down markets, VTA helps investors accumulate positions cheaper.
The key advantage of VTA over DCA and UA can be seen in the fifth, sixth and seventh periods of the up sequence. When the price drops from 88 to 81, the model aggressively buys 162.74 shares. The next period, when the market soars from 81 to 108, the model sells 61.73 shares, locking in profit, boosting IRR, and reducing capital at risk. VTA clearly requires more work than UA and DCA, as it is a continuous recalculating rebalancing process. But it might be worth it.
How would these strategies have performed in real markets from 2000-10? Examining the returns of EM currency, debt, and equity indices using UA, DCA, and VTA on a monthly basis would have generated similar results to our example above, with DCA beating UA, and VTA trumping both. All EM currency, debt and equity indices rose for the period, but all experienced roller-coaster volatility, particularly in the 2002-03 and 2008-09 periods. Indeed, the average volatility for emerging markets was roughly double that of their US equivalents. Which IRRs were best? For the same 10-year investment period, the results are surprising.
Based on the 10-year period ending 31 December 2009 using month-end purchases and sales, VTA lowered the average price and improved IRRs versus UA and DCA in all cases. For emerging market debt, DCA would have enhanced UA per annum returns of 10.14% by 28bps, with VTA adding another 103bps. In the less volatile emerging markets currency sector, DCA beats UA by 19bps per annum, with VTA contributing 40bps more. In EM equities, conditions were the most volatile, creating more buying and selling opportunities: UA generated a 14.86% per annum IRR, with DCA jumping to 16.44% (+156bps) and VTA to a remarkable 18.79% (+397bps).
While it has some weaknesses, VTA can be useful for investors who want to build long-term exposure to more volatile asset classes, like emerging markets. The strategy is particularly well suited for tax-exempt institutions and individual retirement accounts whose buying and selling may have fewer (if any) tax consequences.
Obviously, the strategy cannot guarantee profits if the asset class does not perform well, but it can provide a rational approach for disciplined buys and sells within an allocation rebalancing framework. Buying low and selling high is no easy feat on Wall Street, even for professional investors - but VTA might help investors get closer to this elusive goal.
Peter Marber teaches at Columbia University and is chief business strategist for emerging markets at HSBC Global Asset Management in New York