Emerging market debt has outgrown its benchmarks
New way to invest is an approach that should be completely index agnostic
The emerging market debt (EMD) universe is now around US$17 trillion in size, accounting for around 16% of global securities outstanding. It spans three sub-asset classes, with more than 70 countries, 30 currencies and 1,000 corporate entities. The asset class has reached the point where global investors may be missing out if they do not have meaningful exposure in their portfolios.
However, despite the complexity and diversity of the market, EMD allocation has traditionally been characterized by a benchmarked approach. About 85% of global EMD mutual fund assets remain benchmarked to either hard currency sovereign, corporate credits or local currency bond indices. What often ensues is an inconclusive debate as to how and when to allocate between the three to achieve an optimal result.
For managers unable or unwilling to stray too far from their benchmarks, investors in their funds risk being exposed to negative investment stories – such as Argentina in early August or Turkey in April earlier this year – with no way to de-risk and preserve capital when the narrative starts to deteriorate.
Hard currency benchmarked funds also face missing out on the upside afforded by local currency debt. With a vast array of currencies across the emerging market landscape, funds investing in only dollar (or other hard currency) denominated benchmarked funds can miss attractive long-term income opportunities. There are plenty of low volatility, long-term income opportunities in local currency markets.
In short, the legacy benchmarked approach is of very limited use to exploit the potential of an increasingly differentiated universe where dispersion across countries, sectors and issuers has become the rule.
Against this backdrop, in volatile emerging markets, the new way to invest is an approach that is completely index agnostic and truly unconstrained. That is grounded on income as the core component of portfolio returns but complemented with tactical capital gains from market timing with liquid assets, and alpha generation from more idiosyncratic or relative-value strategies. A process that enables the portfolio to risk and de-risk quickly thanks to a careful management of liquidity risk.
Our portfolio construction process starts with the premise that an EMD portfolio’s “technical” risk profile is key in explaining its behaviour during periods of market stress and is often more important than its “fundamental” risk profile.
As a first step, across all EMD sub-asset classes, each asset in our investment universe is characterised as either a “cash-like”, an “income” generator, an “alpha” provider, or a high market sensitivity “momentum” asset – each of these buckets deliberate for our portfolio to be managed with risk and liquidity in mind.
Success of the strategy is attributable to the repeatable process the team has in assessing both macro and micro factors. The strategy has delivered on its objective over the last six years – capturing the upside for ½ of the volatility and ½ or less of the drawdown.
Take for instance our approach in the recent case of Argentina. Argentina held its primary election on August 11 in the runup to the October 27 presidential election. Although this was a mock election with no impact on the real contest, the perceived inevitability of defeat of the incumbent president to an opposition with a reputation for mismanaging the economy sent markets tumbling.
We believed domestic asset prices had rallied too strongly based on the improvements in Macri’s poll numbers and that the risks were asymmetrically skewed to the downside heading into the PASO, particularly in light of still significant overweight positions. Hence, we made the decision to take profits from our Argentinean positions after a strong run and closed our Argentina exposure going into the primary election in August.
As a result of our unconstrained approach that explicitly manages risk and liquidity, we were able to successfully navigate the market volatility in Argentina.
eVestment data for the last 5 years shows US investors have pulled significant amounts of money from hard currency funds, with almost the same amount flowing into blended currency funds. In Europe, five-year flows into blended currency funds have overtaken hard currency funds.
Conversely, in Asia, hard currency continues to be the dominant allocation and we have seen little allocation to blended currency funds from investors in Singapore and Hong Kong. This approach has potentially prevented investors from accessing the opportunity for favourable risk-adjusted returns.
The past 10 years have been a paradigm of high return and low volatility. We’ve seen global synchronised expansion along with high liquidity and low inflation but this late in the cycle, investors are now faced with a deteriorating risk return trade-off.
At a time of macroeconomic uncertainty around slowing global growth, trade tensions and heightened volatility, investors looking for risk managed income solutions should not only focus on minimizing risk in a portfolio but where the risk/reward profile is compelling, finding ways to capture upside. An unconstrained approach to emerging market debt may potentially provide a cushion for income and offers potential for capital gains across the market cycle.
Suresh Singh is managing director, Principal Global Investors.
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11 Oct 2019