Index to give a risk-controlled exposure to Asian emerging market equity

Abstract

By helping the world move out of recession, Asia has shown its significance in the world economy. Robust domestic demand along with pick up in exports have led to the developing economies in Asia to grow at an impressive rate while the developed world is still struggling to boost consumer spending and growth. This underlines the role that Asia plays in the world economy. Thus, it is not surprising that more and more investors are turning their attention to Asia to become a part of the Asian growth story and earn impressive returns. But the high returns do not come without the risks attached. Asia is considered to be a volatile region since it is mainly export driven economy leading to dependence on several external nations, and also systematic risk which includes political risk, bubble formation risk and overheating risks. Thus investors are concerned to invest in Asia, which indicates a need for a risk controlled index. The currently widely used indices which include MSCI Apex Asia 50 and S&P Asia 50 do not have any risk control algorithm in place and thus have high volatilities, to the tune of 28.54% and 27.29% respectively. Such high volatilities warrant a need for a risk control index. We have prepared an index based on the MSCI indices for Asian countries (China, India, Korea and Indonesia) as components. These countries have selected owing to their high GDPs in Asia along with high GDP growth rates in 2009 which indicate their robust growth and hence are attractive destinations for investment. The index is prepared using several different weight allocation techniques like Sharpe ratio, return and equal weights (passive strategy). Earlier the indices are prepared without any risk control and then the indices are redeveloped with a volatility cap which is adjusted using cash component. This generally leads to slightly lower returns but significant improvement in volatility and Sharpe ratio. The indices are then compared with the widely used Asia focussed indices. We observe that in terms of absolute returns, the one created using Sharpe ratio as weight allocated in a decreasing fashion gives the best result, both with and without volatility cap. The improvement in volatility in case of a cap makes up for the decrease in the return and hence it gives a very high Sharpe ratio of 0.48. This shows that given that the indices belong to the same geographical area, they face the same market and the same risks. Hence, one of them cannot earn high returns as compared to others for same amount of risk. Thus, if one component has high return, a correction is due in the recent future and hence, it makes sense to allocate weights in descending order of the Sharpe ratio. Finally the asset composition of the index in case of risk control shows a higher proportion of cash in times of recession thus indicating that the index actively adjusts its composition to control volatility by investing in cash rather than the volatile equity market.