Tenuous Time for Emerging Markets Calls for Volatility Protection

Tightening monetary policy by the Federal Reserve adds to the downward pressure on emerging markets (EM), making it essential to get volatility protection when investing in EM.

EM performance is typically tied to the performance of the local currency. When the dollar gets stronger due to rising rates, it diverts investment capital into EM and also decreases the value of the local currency relative to the dollar.

With inflation running hot in the U.S., it’s only a matter of time before the Fed starts to raise rates. According to the International Monetary Fund (IMF), there are already signs that a strengthening dollar is having a profound impact on countries that are sensitive to its strength.

“Faster Fed rate increases in response could rattle financial markets and tighten financial conditions globally,” an IMF Blog post says. “These developments could come with a slowing of US demand and trade and may lead to capital outflows and currency depreciation in emerging markets.”

“The impact of Fed tightening in a scenario like that could be more severe for vulnerable countries,” the blog says further. “In recent months, emerging markets with high public and private debt, foreign exchange exposures, and lower current-account balances saw already larger movements of their currencies relative to the US dollar. The combination of slower growth and elevated vulnerabilities could create adverse feedback loops for such economies, as the IMF highlighted in its October releases of the World Economic Outlook  and Global Financial Stability Report.”

An ETF to Curb Volatility in EM

One way to counter volatility is to focus on quality — getting access to EM equities that can withstand market shocks. Investors can get all this in one ETF: the FlexShares Emerging Markets Quality Low Volatility Index Fund (QLVE).

The fund seeks investment results that correspond generally to the price and yield performance of the Northern Trust Emerging Markets Quality Low Volatility Index. This index is designed to reflect the performance of a selection of companies that, in aggregate, possess lower overall absolute volatility characteristics relative to a broad universe of securities domiciled in emerging market countries.

“QLVE tracks a proprietary index of emerging markets companies which aims for a portfolio bias toward quality and reduced volatility,” an ETF Database analysis explains. “The index methodology first assesses financial strength and stability based on quality metrics like profitability, management efficiency and cash flow.”

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