Emerging market investors looking to reduce volatility on their returns should combine stocks, bonds and currencies, according to a report by asset management firm Alliance Bernstein, called "An all-encompassing approach to emerging markets".
"An integrated multi-asset approach reduces portfolio volatility by providing greater diversification potential and opening up a wider range of hedging opportunities," the report said.
The report said that an integrated approach to emerging market investment is still rare, due to the relative youth of the sector, particularly its bond markets.
However, the number of countries listed in JPMorgan`s index for dollar-denominated sovereign debt reached 41 in December 2010, up from 31 in December 2001.
During the same time period, the proportion of countries in the JPMorgan EMBI Global index that were rated investment grade rose from 27% to 57%. Average yield fell from 11.6% to 6.1%, with spreads falling from 644 basis points to 289 basis points.
The report said: "Many emerging economies have now developed full government bond yield curves , making it possible for investors to fully separate the decisions on interest rate and currency risk."
By moving between asset classes on an ongoing basis, investors can gain exposure to those countries that don`t yet feature in standard emerging market indexes for bonds and stocks.
For example, Taiwan and South Korea are among the larger country components for emerging market stock benchmarks, but are not included in some bond benchmarks. As "frontier" markets, Argentina, Lebanon, Kazakhstan, Pakistan, Sri Lanka and Vietnam feature in bond benchmarks, but not standard stock benchmarks.
Regarding frontier markets, the report said: "The `frontier` designation puts the country`s companies off-limits for institutional investors. This artificially suppresses potential demand for shares and creates opportunity for unconstrained investors to get in at better prices for the upside potential of earnings growth."
By purchasing currency in addition to stocks and bonds, investors are able to hedge against local currency risk, said the report.
As an example, the report said an investor could buy shares in a Turkish exporter in the hope that the company`s competitiveness will improve from a weakening Turkish lira, while simultaneously shorting the currency so that its depreciation does not affect the principal value of the stock.
However, the report advocated caution with regard to emerging market corporate debt. "The universe of issuers is still relatively small, and liquidity is a major concern, with the average trade less than half that of the average sovereign emerging market bond," it said.