The Year in Risk: Developed and Emerging Markets Diverge

2013's changing risk patterns pushed investors to swap index funds for country-level investments, according to Axioma.

(December 18, 2013) — A divergent trend in developing and emerging markets’ (EM) risks marked a significant change in how investors allocated to EM assets, according to Axioma.

Melissa Brown, senior director of applied research at Axioma, concluded that market risk peaked in the second quarter of 013—a result of tapering talks by the US Federal Reserve.

“Although it was a ‘risk off’ for many investors at mid-year, large cap US stocks ended up having their best year since 2003, despite the government shutdown, with consumer discretionary stocks leading the way,” Brown told aiCIO.

Emerging markets took a bigger hit from the Fed’s announcement—its recent decline in risk has been steeper, leading to a wider gap between developing and emerging markets.

The risk, Brown found, had mainly shifted eastward to Asia-Pacific markets. While North American and European markets’ risk fell after the second quarter, Asian markets had largely remained flat.

“One of the most significant trends of 2013 was the continued decoupling of developing markets from emerging markets,” Brown said. “We saw it across the board, in equity, bond, currency, and credit default swap markets. The divergence of risk and return had major investor implications in terms of stock and country selection in emerging markets.”

This trend led investors to be more discerning with their allocations in emerging markets: they could no longer be tied together as one unit.

“Lower correlations, along with the changes in risk geographically, resulted in investors becoming much more discriminating,” Brown said. “In the absence of a single overarching theme driving returns, investors placed their bets based on the individual merits of countries and individual assets within countries.” 

These lower factor and asset correlations helped decrease risk in developed markets but less so in emerging markets, as high factor volatility could counterbalance the decline.

Brown said looking ahead, one could expect country selection in emerging markets to become critically important. However, understanding the risks undertaken for each individual countries should also play a greater part: 

“You want to make sure that you’re in the right countries, estimating the risk properly for the markets you’re in in,” Brown told aiCIO.

“Volatility typically follows volatility. The chances are it’s going to be a while until the risks settle down.”

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