New Emerging Market ETFs: Carving Up Betas Is Only a Partial Solution

James Picerno submits:

More is better when it comes to asset allocation, at least in theory. But how much is too much? Common sense suggests that there's a point of diminishing returns to dividing up portfolios into ever finer slices. Exactly where that point lies is unclear, however. That's partly because analyzing widely divergent portfolio choices rapidly spins out of control as a quantifiable research project intent on dispatching a few concise insights. Reviewing the infinite, in other words, doesn't help much in the search for one-size-fits-all advice.

The issue is topical once again with the recent launch of the first style-focused emerging market equity funds. A pair of new funds divides this beta into two ETFs: Global X Russell Emerging Markets Growth ( EMGX ) and Global X Russell Emerging Markets Value ( EMVX ). Emerging market stocks have traditionally been securitized as one market-cap weighted portfolio, as represented by, say, iShares MSCI Emerging Markets Index ( EEM ) or Vanguard MSCI Emerging Markets ( VWO ).

Carving up risky assets into finer slices isn't new, nor is it a radical notion. You can trace the idea back a few thousand years to the Talmud, which recommended the diversification of wealth into liquid assets, property and commercial enterprise. In the modern era, the idea of managing asset allocation dates to Markowitz's famous 1952 paper "Portfolio Selection," which introduces the concept of quantitatively optimizing the mix. The conventional interpretation of Markowitz (1952) focuses on individual securities, although the paper notes that "aggregates, such as, say, bonds, stocks and real estate" can be used as inputs.

The subsequent theory and practice of asset allocation in the decades since Harry Markowitz penned his seminal study has evolved considerably, of course. The basic intuition of diversifying, backed up by the progression of finance theory and the empirical record, makes a powerful case for investing across the major asset classes. The good news is that owning a multi-asset class portfolio is getting easier every year with the proliferation of ETFs.

In broad terms, the investable "market portfolio" can be defined as 12 major asset classes, plus cash. We're talking here of standard betas in long-only, unlevered form that are available as ETFs, ETNs, and mutual funds. The key reason for owning individual pieces of the so-called market portfolio is bound up with exploiting the rebalancing bonus. Because the various markets exhibit something less than perfect correlation through time, there's considerable opportunity for reweighting the portfolio by selling high and buying low.

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The choices above provides a rich opportunity set for earning a reasonable risk premium. In fact, using the ETF proxies for each of the asset classes above can deliver a wide array of outcomes, from relatively tame portfolios to hedge fund-like results. It all depends on how you weight the individual pieces initially and how you manage the volatility.

Dividing one or more of the major asset classes into additional parts can enhance the possibilities for earning higher risk-adjusted returns, but you need to think carefully about going too far down this road and applying the concept to more than one or two asset classes. If you can't earn a sufficiently satisfying return with the broadly defined betas listed above, it's not obvious that you'll do much better by holding a more granular asset allocation. If it were otherwise, building portfolios with individual securities would be a short cut to beating the relevant market index. But the historical record from thousands of mutual funds suggests that mediocrity is the path of least resistance.

What is clear is that owning a broad mix of different asset classes and rebalancing the mix periodically represents a robust strategy for earning decent and perhaps exceptional results. The biggest challenge is less about expanding the set of risk factors beyond the list above vs. embracing a contrarian-oriented investment strategy. Taking advantage of volatility is at the heart of earning superior risk-adjusted results. It's a simple concept, and yet relatively few investors come anywhere near taking full advantage of the benefits.

Over the course of a business cycle, there's likely to be wide range of correlations across the major asset classes. In addition, these correlations will fluctuate by more than a trivial degree. And most, probably all, of the standard asset classes have positive expected returns for the long term, albeit in varying degrees. There lies the raw material for earning something better than average returns. Yes, you can do better by focusing on a more granular definition of betas. Indeed, most of the major asset classes can be broken up into numerous pieces. But if you're not successful in exploiting the basic choices, slicing up broad betas into multiple parts probably isn't going to help.

See also March Stats: U.S.-Listed ETP Assets Grow to $1.078 Trillion at End of Month on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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