July 2019 - Barron's - How to Bet on Emerging Markets as Interest Rates Drop

By Steven M. Sears July 5, 2019 5:15am ET - The detente in the U.S. and China trade war, coupled with central banks’ potential move to more-dovish policies, merits increased exposure to some of the world's riskiest investments.

If the Federal Reserve and European Central Bank lower interest rates, emerging markets are likely to move higher. A top BlackRock portfolio manager is recommending that clients increase their exposure. When rates are high in Europe and America, investors are often less willing to endure the higher risks of emerging markets. But if rates are low and money is cheap—and rates could be cut again—investors often take more risks and buy emerging market stocks and debt.

Of course, the inability of banks to normalize monetary policy is a doubleedged sword. If global economies were healthy, banks would raise rates to temper growth. The fact that the ECB and the Fed have recently hinted at lower rates, coupled with unresolved trading differences between the U.S. and China, arguably doesn’t signal healthy long-term conditions. But we must take things as they are.

Easy financial conditions typically benefit emerging markets more than developed economies, according to Russ Koesterich, a portfolio manager on BlackRock’s Global Allocation team. In a post on his firm’s blog, he noted that changes in financial conditions have explained more than 75% of the variation in emerging market returns since 2010.

Easy financial conditions also explain a similarly large percentage of developed-market returns, but the volatility in emerging markets has been greater. Unlike 2018, central banks are no longer talking about normalizing policy, but rather stimulating the economies yet again. “In this type of environment, it is often the riskiest assets that gain the most,” Koesterich noted.

If you agree, consider buying the iShares MSCI Emerging Markets exchangetraded fund (ticker: EEM) and making concentrated bets on some leading China stocks, such as Alibaba Group Holding (BABA). Focus on upside call options that are 5% or so above the current market price and that expire in six months. (Calls increase in value when the underlying security price increases.) This should provide enough time for the emerging market thesis to evolve, while creating enough of a buffer should the trade-war detente fizzle. The goal is simple: define risk while establishing upside.

Speaking of probabilities, Thomas Peterffy, chairman of online broker Interactive Brokers, is hosting another teach-in in his own inimitable way. He is following up on his Probability Lab with a Simulated Sports Betting Exchange. Participants can buy, sell, and trade bets on real tennis, soccer, and baseball games. The first 2.2 million people who open an account will get a virtual deposit of $1,000. Winnings can be converted into Interactive Brokers commission credits.

Peterffy says he hopes this teaches people to think about the probabilistic nature of markets, trading, and investing, while attracting them to the brokerage firm. The betting exchange should be up and running by Wimbledon’s quarterfinals.

The offering might seem incongruous with investing, but the underpinnings are the same. One basically determines the odds of events and wagers accordingly. For Peterffy, sports sparked his fascination with probabilistic thinking and determining the odds of events. When he was just 8, he went to horse races with a friend and his friend’s father in communist Hungary. He remembers people tossing losing tickets on the ground, only to try to find them when someone objected to the race’s outcome and the winners were changed. Peterffy and his friend would search for the suddenly valuable tickets. “This was the first serious money I ever made,” he said.

He used that understanding of process and odds to great success. He was the first person to use computers to trade options, ultimately founding Interactive Brokers to democratize technology and markets. He is now focused on teaching people about probabilities and investing in ways that do not require advanced knowledge of math.

Steven M. Sears is the chief investment officer at StratiFi Technologies.