Frequent crises in emerging markets have brought investors high volatility and disappointing performance over the last 30 years. But those same crises can also serve as a source of excess returns, according to a new study from Verdad Advisers.
The asset management firm, founded by chief investment officer Dan Rasmussen, this week published the findings from an analysis of “every EM crisis since 1987,” including 71 crises in the 18 most tradeable emerging markets. The study defined crises as periods when major emerging markets experienced equities drawdowns of at least 50 percent, including crises caused by global recessions and more localized events.
For buy-and-hold investors in emerging markets, these “frequent and severe” crises have resulted in decades of underperformance: According to Verdad, $100 invested in emerging markets in 1987 would be worth $1,340 today, compared to $1,890 if it had been invested in the Standard & Poor 500 index.
[II Deep Dive: The Signals Coming from the Emerging Markets Petri Dish]
“Paradoxically, these crises are caused by EM bulls who inject vast amount of capital into these markets, causing them to crack either from unsustainable growth or from negative macroeconomic effects,” wrote Rasmussen and co-authors John Klingler, Georgi Koreli, Nick Schmitz, and Igor Vasilachi. “When that happens, those same promoters are quick to pull their capital out of the country, amplifying the crisis even further.”
But there is a way for investors to outperform in emerging markets, according to the Verdad team. Rasmussen and his co-authors determined that investors could reap excess returns by “providing capital when no one else does.” They said this approach, which they called “crisis investing,” has historically beat not only a buy-hold strategy in emerging markets, but the S&P 500 as well.
Specifically, the Verdad team proposed a three-part strategy using emerging-market large value stocks, emerging-market sovereign debt, and U.S. sovereign debt. They suggested holding emerging-market stocks for two years immediately after global crises, holding emerging-market debt for two years after crises that are idiosyncratic to a country or region, and holding U.S. sovereign debt when the portfolio was not invested in either emerging-market debt or equity.
According to the report, this strategy delivered a 16 percent annualized return between 1993 and 2020, versus a 4.7 percent return for MSCI’s emerging-market equity index. The S&P 500, meanwhile, gained 9.5 percent annualized over the same period.
At the same time, Verdad’s crisis investing strategy was less volatile than both emerging markets and U.S. stocks, with a maximum drawdown of 19 percent, versus 51 percent for the S&P 500 and 61 percent for the MSCI emerging market index.
“A crisis investing strategy… could represent an attractive alternative to a buy-and-hold approach to emerging markets,” Rasmussen and his co-authors wrote. “This strategy results in equity-like returns with debt-like downside protection, based on our analysis.”