It has been an interesting few weeks in global markets, with political routs, an escalating trade war and a hawkish Fed weighing on confidence across asset classes. 
This combination has proven particularly potent to export-dependent emerging markets, where rising currency pressures have amplified prevailing concerns about corporate credit risk. Institutional investors are, by and large, woefully underweight in these markets, more so on the debt side, and the move into ‘risk-off’ across the region will do little to shift that dial.
Economies with large current account deficits are a tough sell for even the most bullish of investors at the moment, and, with a weather eye on the near-term trajectory for Treasury yields, the Fed’s next move and shrinking US balance sheets, there looks to be little promise of relief through the heat of what looks to be a long and testing summer. The recent addition of Saudi Arabia to the MSCI Emerging Markets index may also add another, complex dimension to those tracking the index – formalising the influence of Gulf politics and its market idiosyncrasies in market weighting.
Mutable market conditions will, logically, give rise to different investor behaviour and drive a departure from the momentum trades which have featured prominently in the last few years. In more volatile markets – as inflation concerns push up bond yields and the unwinding of quantitative easing poses potential liquidity challenges – some investors may well take the decision to cut and run from the emerging markets rout.
As much as recent market commentary has focused on the relative ills of asset classes and regions, it has also, inevitably, strayed into the well-trodden debate around active versus passive. Now familiar territory, this discussion has driven hyperbole around the shortcomings of investment structures, too often at the cost of a wider assessment of more seismic structural shifts underway across markets.
It is important to acknowledge that trading in emerging markets and, indeed, across global markets through recent volatility has been executed under a very different set of conditions to the pre-crisis era. Shrinking balance sheets and the proliferation of dealing venues has altered the backdrop near universally across asset classes, particularly on the fixed income side. Historically, market makers could step in and provide the other side to trades through a run-off, but in the post-crisis environment, investment banks and other market makers are increasingly hamstrung in their ability – and lacking incentives – to take on balance sheet risk.
As a result, the less liquid the underlying asset, the uglier a single day can get – presenting the greatest challenge to more inefficient, illiquid markets. We have seen bouts of this in the past, including the high yield sell off back in 2015. While this is yet to play out in emerging markets, with countries including Argentina, Turkey starting to really come under pressure, big drops and jumps in pricing are almost unavoidable and much of that is tied to market structure.
Of course, forced sell-offs bring both dangers and opportunities for investors, which in current markets, could prompt a shift away from strategies pegged to a benchmark. In more volatile conditions, oversold areas will likely give rise to valuation opportunities for active investors, for whom the ability to undertake fundamental analysis and express long-term views will endure in even the most illiquid asset classes.
If the decade of steady – near unnatural – calm is indeed at an end, investors may well review their tack. Many will prioritise flexibility and protection as they review allocations, but equally, seek to access long-term value in the most efficient way.
Against this backdrop, the fund selection world is becoming increasingly polarised, in that active and passive vehicles are developing very distinct, specific roles in the context of a diversified portfolio. Skilful portfolio construction is now, in large part, a question of finding ways to blend and maximise the complementary nature of these two approaches, hitherto set against one another.
Exchange-traded funds will continue to show their worth in efficient and highly liquid markets. Additionally, even through more volatile conditions, they can be effectively harnessed to tap into long-term, thematic megatrends. Investors who believe that demographics and structural changes drive markets will naturally seek access to these themes, which can be expressed in portfolios via tactical or thematic tilts.
Active funds, on the other hand, will continue to add value in less efficient, liquidity-constrained markets. At a time when investors are looking for ‘bang for their buck’ in asset allocation terms, the most efficient portfolios will seek solutions which, when markets really come under pressure, can combine the best of both worlds.
Nick Lyster is global head of wealth advisory services at Principal Global Investors. The views expressed above are his own and should not be taken as investment advice.