In a recent research note, we investigated whether allocating part of an investor’s portfolio to emerging markets equities adds value to a global equity portfolio. Using market data over the period from January 1988 to December 2017, we investigated whether investors should allocate to emerging stocks and how they should go about it.

More specifically, we considered two main options. The first is based on a passive allocation that replicates the MSCI Emerging Markets Total Return Index. The second involves allocation to the well-known value and momentum factors, within the MSCI Emerging Markets Total Return Index investment universe, using a ranking approach, as well as relatively simple factor definitions and portfolio construction rules (investing in the 33% most attractive stocks from a factor perspective, with monthly rebalancing).

We found that, historically, allocating part of an investor’s portfolio to passive emerging markets equities increased the portfolio’s risk-adjusted return. However, the gains of allocating to emerging markets are far greater when value and momentum factors are taken into account in the stock selection process. The benefits of allocating to factors in emerging markets can be significant, even when factor investing is already implemented in the developed markets part of the portfolio.

In our analysis, we also considered more sophisticated portfolio construction rules that do not entail the immediate sale of stocks that become less attractive in terms of factor exposure. Instead, every quarter, only stocks that are no longer among the top 50% are sold. These stocks are then replaced by the most attractive stocks at that time not yet included in the portfolio. Our calculations showed that compared to a more static approach, this dynamic approach leads to both lower turnover and higher returns.

Based on prudent assumptions, we also looked at the impact of transaction costs and management fees on performance. More specifically, we assumed trading costs of 30 basis points for developed markets stocks and 50 basis points for emerging markets stocks. We also assumed annualized management fees of 10 basis points for passive developed markets, and 20 basis points for passive emerging markets. An additional 10 basis points per annum mark-up was included for the factor portfolios. Our conclusion is that even once these costs have been incorporated, allocating to emerging markets factor premiums still adds substantial value.

Finally, we analyzed the performance of the different investment strategies over two equal sub-periods: from January 1988 until the end of 2002 and from 2003 until December 2017. The results in both sample periods were in line with the findings for the overall sample. Allocating to emerging markets improved the Sharpe ratio of the portfolio in both sub-periods, and allocating to the value and momentum factors further improved the Sharpe ratios.

As result, we advise investors to allocate part of their portfolio to factor premiums in emerging equity markets, all the more so given that the factor definitions used in our study are relatively simple. We argue that efficient factor investing strategies using enhanced factor definitions, as well as smart rules for stock selection and portfolio construction, can achieve even better investment results, while lowering both risks and costs.

Robeco has been successfully running factor-based portfolios in emerging markets for over ten years now. Since its launch in 2008, our Active Equities strategy has proven its ability to consistently and significantly outperform the MSCI Emerging Markets Index, both in up and down markets, delivering positive excess returns in eight out of nine full calendar years.