Investors should beware of a growing ‘diversification decay’ problem that is evident in many emerging market portfolios, according to a global investment manager.
Eaton Vance’s emerging markets debt team noted three related important trends since the global financial crisis: increased EM debt holdings by mutual funds and institutions, index-based EM portfolios, and more frequent risk-off/risk-on episodes.
“Taken together, these trends are changing the nature of EM index risk – it is becoming more like systemic, developed-markets risk. For the majority of EM debt investors looking for exposure that doesn't mirror trends in developed markets, this can represent worrisome ‘diversification decay’,” it said.
Eaton Vance said diversification decay is a growing problem for the many EM portfolios tied to JPMorgan’s Government Bond Index – Emerging Markets.
However, it also believes it can be largely avoided through active strategies that focus on country-level macroeconomic and political research, and standalone analysis of specific risk factors such as currency, credit spreads and interest rates.
“Standing apart from the indexation herd in this fashion through active strategies like those pursued by the Eaton Vance Global Income team can potentially preserve the important diversification benefit of EM debt investing,” Eaton Vance said.
“Investments in foreign instruments or currencies can involve greater risk and volatility than US investments because of adverse market, economic, political, regulatory, geopolitical, currency exchange rates or other conditions. In emerging or frontier countries, these risks may be more significant.
“Diversification does not guarantee profit or eliminate the risk of loss.”