By Morgan Harting After five difficult years, signs of life are emanating from emerging markets. Investors seeking to rediscover the developing world might consider the benefits of pulling more levers across asset classes. Since the global market correction in January, investors have been taking a fresh look at emerging markets. The MSCI Emerging Markets Index has risen by 21% since January 21 in US dollar terms, through March 21, outperforming global developed stocks. Meanwhile, the J.P. Morgan Emerging Market Bond Index has advanced by 7%. Fund flows to emerging market equities and debt have been positive for several weeks following three years of net outflows for equities and one year of net outflows for bonds. Improving Risk-Adjusted Returns Yet for many investors, emerging equities still seem scary. They’re much more volatile than their developed market peers, so there can be a cost to accessing their return potential. That’s why a multi-asset approach can be very effective. By reducing risk significantly, it can help investors maintain exposure to the underlying long-term growth story that underpins the attraction of investing in the developing world. Our research compared the risk-adjusted returns of four approaches in emerging markets: 1) a cap-weighted equity index; 2) a skillful tilt toward better-performing equity countries and sectors; 3) a multi-asset approach that bolts together equity and debt indices; and 4) a portfolio that skillfully tilts toward the top-performing-quartile country and sector within each asset class. Bolting together emerging market stock and bond indices would have outperformed an allocation to passive equities – and generated stronger risk-adjusted returns than even a skillful stock picker could have achieved (Display). But an equally skillful multi-asset manager that tilted toward better-performing countries and sectors in stocks and bonds would have done even better, our research suggests. Click to enlarge Stocks and Bonds Move in Tandem Why does an integrated multi-asset approach work so well in emerging markets? Performance patterns can help answer this question. Stock and bond markets in developing countries are highly correlated, meaning they tend to move in the same direction. But emerging stocks are also much more volatile. As a result, when investors are optimistic about a country’s growth prospects or diminishing risk, capital inflows to local markets often fuel gains for both stocks and bonds. Conversely, concerns about financial stability or recession usually hurt both asset classes. Higher bond yields trigger an increase in the discount rate applied to company earnings, which pushes down stock prices. Take the recent example of Brazil, which slipped into recession last year. Investors sold both Brazilian stocks and bonds, which declined 41.4% and 13.4%, respectively. More recently, as investors became optimistic about a potential change in government, Brazilian assets have rallied, with stocks and bonds up by 29% and 12.7%, respectively, for the year through March 21. So combining emerging stocks and bonds in a single portfolio preserves the underlying risk exposure, but at a significantly lower level of volatility, in our view. And the reduction in volatility will often outstrip any reduction in returns, underpinning a dramatic improvement in risk-adjusted returns, as shown above. Dispersion Within an Asset Class Isn’t Enough Brazil’s recent volatility highlights the challenge. The emerging equity index spans 24 countries and nearly as many industries, affording an active manager ample opportunity to take active positions and outperform an equity index . Yet, when emerging stocks collectively face downward pressure, there aren’t enough places for an equity-only manager to hide. Last year provided a good example when the emerging equity index fell 15%. The quilt display below shows that India was the top-quartile segment in equities, falling 6%, while the worst quartile was Mexican telecom, down 31%. So even if a skilled manager put all of her eggs in the top equity quartile basket, the portfolio would have suffered significant losses. Click to enlarge Widening the opportunity set to include bonds could have dampened the downside risk. Even the worst-performing quartile of dollar-denominated government bonds – Tanzania – outperformed the best equity quartile. This dynamic is not unusual. The worst quartile of dollar sovereign bonds outperformed the best quartile of equities in 2011, and in 2008 as well. Combining emerging-market equities and bonds in a multi-asset portfolio gives a manager more options to find the right balance of returns. We believe this type of structure can provide a strategic advantage over bolting together independent equity and bond portfolios. It’s too early to say whether the tide has definitively turned in emerging markets. But recent enthusiasm might be a signal for investors who are underexposed to emerging markets to think about reentry. By pulling more levers from the broadest universe of securities in a portfolio of carefully chosen stocks and bonds, we believe investors can regain the confidence to return to emerging markets and capture smoother return patterns through the volatile conditions ahead. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.