Monday, October 24, 2016

Emerging market investing - Play the skew

Skew can be an important component of returns. Obviously, investors would like to avoid negative skew, but if an asset with a positive skewed return distribution can be found, it can potentially generate a nice upside stretch with performance. Still, skew is sensitive to outliers and hard to measure. Skew is often generated from mixed distributions; nevertheless, if you can find positive skew investments and can associate this property with specific factors, portfolios can be structured to generate some extra upside return potential by increasing allocations to these assets.

Positive skew has been found in emerging market equities and it is systematically related to economic factors that can be measured and independent of developed market behavior. See "Why Invest in Emerging Markets? The Role of Conditional Return Asymmetry?" in the Journal of Finance. This work makes intuitive sense and is relatively simple to apply through the use quantile-based measure of skew. (The authors use a variation of Bowley's statistic first developed in 1920.)

This positive skew effect is stronger for EM relative to developed equity markets. The result of these finding is that portfolios should be tilted to EM country exposures that have less negative skew. Moreover, the authors find that the positive skew is related to the degree of financial and trade openness. In particular, those countries that may be less sensitive to "sudden stops" in currency markets will have more positive skew. Financially open but trade closed economies will show more negative skew. When portfolio allocations are made which account for quantile skew measures, EM markets will be given significant higher weight and will result in stronger returns. If you want more distributional upside, hold more emerging markets.

Given these results, it would be interesting to test the same novel approach to measuring skew with assets other than equities. For example, hedge funds strategies that may have more positive skew should also have greater allocation tilts within a portfolio. 

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