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Parametric Combines Emerging and Frontier Markets for Diversification

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Even as far back as 1994, when most of the established emerging markets of today were frontier markets, and the only readily available index was the International Finance Corp.’s Emerging Market Database, Bob Breshock and Greg Johnsen, managing director and senior portfolio manager, respectively, at Parametric Portfolio Associates, believed firmly in diversification as the best long-term strategy for investing in developing markets.  

Today, the world has changed a great deal and there are multiple indices to follow and a swath of countries to invest in that were not anywhere close to being on the map in 1994. But for Parametric, which manages the Parametric Emerging Markets Fund and the Parametric Tax-Managed Emerging Markets Fund, diversification is still the name of the game.

“We came to it and we still are from the desire to build a portfolio that can deliver a lower volatility experience, since volatility can damage returns, and that means that broad diversification is very important for us,” Johnsen said. “Back then, we were looking at getting broad country exposure and we still are.”

Unfortunately, most indices, both in 1994 and today, don’t really allow for the kind of broad diversification that Parametric wants. For instance, the popular MSCI Emerging Markets Index, for instance, has a two-thirds weighting toward the five largest emerging markets countries and ditto for the FTSE Emerging Market Indices, Johnsen said.Johnsen

Avoiding those concentrations and the correlations they’re bound to result in is the best way forward, he said, and that’s why Parametric chooses to spread assets between standard emerging markets and frontier markets.

The fund separates its investments into four tiers of country weights (it started out with two in 1994) and invests in 1,500 securities (compared to an index that typically contains only 700 or 800 stocks) in 43 different countries, frontier as well as emerging. The team is looking for liquidity as well as other factors such as investor-friendly provisions at the country level, currency repatriation, legal infrastructure and so on.

“We work to avoid concentration but the hallmark of our approach is migration,” Breshock said.Breshock

Stocks are constantly migrating between cap sizes, from mid to large and back again, “and they don’t know what cap or style they are,” Breshock said. The same is true for countries around the world. “They’re not aware whether they’re frontier or emerging market, and as they move up from one category to the other, some of them also move back. Which means that if you have artificial segmentation and you invest separately in emerging markets and frontier markets, you have to sell out of one to buy the other every time there is a movement, so we believe it’s best to include frontier markets with emerging markets,” he said.

By combining frontier market exposure with emerging market exposure, there is no need to sell off positions in countries that graduate to a larger market status, Breshock said. Furthermore, frontier markets have a low correlation to emerging markets, which means there’s lower volatility in Parametric’s portfolios. Finally, frontier markets do not necessarily achieve their greatest growth as frontier markets: In fact, they realize their true growth only when become emerging market countries, so being able to move in a fluid manner between these two groups is vital to cash in on that potential.

“We really want to reduce volatility across the countries we invest in and also have low cross-correlation,” Johnsen said. “We put that in tandem with a disciplined rebalancing mechanism—selling those stocks that have run up substantially and buying those that are down on an ongoing basis — and we look at a combination of modified equal weights [between country tiers], and that is how we give clients exposure to a whole range of opportunities.”