Emerging Market Debt: Going multi-asset
First it was equity, then bonds - and most recently investors have been exploring emerging market currencies. Martin Steward asks if it pays to bring the three together
Last year, when investment consultant Lane Clark & Peacock (LCP) went in search of managers to run combined portfolios of emerging market (EM) equities, bonds and currencies, it appeared to have trouble finding exactly what it wanted. A Capital International strategy fit the bill, but to offer choice to their clients the firm felt compelled to ask competitors if they could put together something similar (in the end they chose to work with Lazard Asset Management and Barings, as well).
The idea was not as new as this suggests. PIMCO was running its Emerging Multi-Asset strategy; Ashmore offered a Multi-Strategy fund; JPMorgan Asset Management (JPMAM) created a product in 2010; the strategy behind LFP’s Patrimoine Emergent fund has been in place for some years; and Invesco has offered an Asia Balanced fund since 2003.
But a head of steam has indeed been building since: new products were launched this year by Carmignac Gestion, AllianceBernstein and RCM, and more are in the pipeline from UBP and HSBC Global Asset Management (which has long managed a white-label version for a European insurer).
The numbers could be augmented further by the many providers of alternative approaches to EM - take Matrix Asset Management’s macro-style Redux EM fund, for example, or the Calamos Emerging Markets fund recently seeded by the Superannuation Arrangements of the University of London (SAUL), which combines equities with convertibles. These are now more likely to align themselves with more traditional-looking ‘balanced emerging’ portfolios.
Small wonder. More institutional buyers are expected to follow SAUL and LCP’s clients. JPMAM reports keen interest from US pension funds and Capital and PIMCO were the beneficiaries of a recent $800m-plus allocation to EM multi-asset by the $41bn Alaska Permanent Fund.
So what are the advantages of multi-asset exposure in these markets? And why get it under the same mandate, rather than retaining separate bond and equity specialists?
Most institutional investors started out in EM with equities, but in the aftermath of the 2007-08 financial crisis bonds and local currencies have become two of the hottest asset classes around. It was only a matter of time before the ‘balanced portfolio’ logic - combining equities and bonds for a better risk-adjusted return - would be applied to EM as it is in DM.
Sure enough, coming from the equity starting point, adding bonds does improve the Sharpe ratio. Since 1994, EM equities returned 5.3% annualised with volatility of almost 25%, while a 50/50 portfolio rebalanced biannually returned 9% with volatility of 17%.
“We think that clients ought to have greater exposure to the transfer of wealth to emerging economies, but equities in general and emerging market equities in particular are volatile,” says LCP partner Paul Gibney. “While schemes are de-risking we don’t think urging a higher allocation to EM equities alone is the best way to encourage that increased exposure.”
Asset managers have picked up on this, too. “The essence of our strategy is that we knew our clients wanted more EM exposure, but remained apprehensive about the volatility,” says Morgan Harting, senior portfolio manager at AllianceBernstein. John Calamos, running the very different EM equity-plus-convertibles strategy at Calamos Investments, makes a similar argument: “The objective is an equity objective rather than a balanced or fixed income objective - we look to outperform the equity benchmarks with less risk.”
But if you start with bonds, the picture looks very different. That improvement in Sharpe ratio does not come from any diversification benefit in the bonds. Figure 1 shows that the crisis pushed correlation back above its long-term average of 0.65. That high reading is all the more striking given the fact that the two indices look very different: crudely, the equity index delivers a lot of Asia (and high growth rates) and the bond index much more Latin America and emerging Europe (and high real interest rates).
The improved Sharpe comes entirely because, over the past 17 years, EM bonds have returned 10.2% annualised (twice the return from equities) with volatility at 13.2% (half that of equities). So why on earth would anyone choose to add equities if it means bumping volatility up by 380 basis points in exchange for 120 basis points less return?
“We had to recognise that the historical data offered no reason whatsoever to put anything into equities,” concedes Keith Swabey, head of product development in the global multi-asset group at JPMAM. “But the consultant who approached us wasn’t comfortable with that, and the numbers we ultimately came out with were more like 40% as a neutral allocation.”
Is that just hidebound devotion to equities? Not necessarily. Swabey notes that investors need to be forward-looking in fast-developing markets, and on that basis there is a statistical case to be made for adding or retaining equities, and an economic one, too.
We have seen that there is no benefit in terms of lower volatility when we add equities to bonds. But returns from bonds show a pronounced negative skew and considerable excess kurtosis (a high peak around the mean and a fat left tail). The negative skew of equity returns is much less pronounced; and higher volatility comes with the hidden benefit of much lower excess kurtosis. Bonds come with the outside chance of deep left-tail losses, but because upside is limited to coupon and principal payments they don’t deliver the opportunity for deep right tail wins as equities do. The same holds true in DM, but the higher volatility of EM means that the dispersion between equity and bond upside is that much greater.
Clearly, there are times over the past 17 years when the downside volatility protection of bonds has been the thing to have. But take another look at figure 1: between 2004 and 2008, equities were catching up rapidly as the emerging equity risk premium was re-rated.
The global crisis was a setback, but today it would be brave to forego the potential upside from equities on the basis of historical volatility-adjusted returns - particularly when you have the option of dampening some of that volatility with bonds. That brings us to the economic argument for equities.
“The volatility of bonds may remain the same, but I would not expect the very high returns that we have seen to be sustained into the future,” says Herold Rohweder, global multi-asset CIO at RCM, whose Dynamic Emerging Multi Asset strategy runs a largely top-down strategy with a neutral allocation of 40% equities, 40% bonds and 20% currencies. “Bonds have benefited from two things: a very high risk premium in the form of a credit spread, which has already narrowed significantly; and the interest-rate cycle, which is now about as low as it can get.”
One can argue for other reasons why debt should have outperformed equity up until now. As LFP’s head of EM, Thomas Fallon, says, few argue that an EM allocation is about diversification anymore - it’s all about making a claim on the superior economic growth. “At that point the debate centres around which countries, and which securities on each country, mark the most efficient way to make a claim on that growth.”
The textbooks describe economic growth as the sum of consumption, government spending, investment and net exports. Equities certainly offer exposure to the consumption and exports part of the equation, but positive sensitivity to government spending will be very mixed, and investment growth probably favours corporate bondholders.
“The equity return is really only going to capture one component of ‘C+I+G’,” says Jai Jacob, manager of the Lazard Emerging Markets Multi-Strategy portfolio. “You’re missing a lot, particularly where governments still play a prominent role in the fortunes of economies and companies.”
Bonds are good for exposure to increasing net exports, which boost current accounts. If this leads to appreciating exchange rates, local currency bonds benefit. And as governments have used healthy coffers to develop their infrastructure, bonds have provided good exposure to these (largely debt-financed) projects. Moreover, the inevitable misallocation of capital that goes on in fast-growing economies, while rarely good for return to equity, still generates tax revenue.
But, of course, from here onwards, the equity risk premium might well assert itself as governments withdraw from the economy, domestic consumption takes over from export-led growth and the global economy rebalances.
“Should investors seek exposure through equities, debt or currency?” asks Curtis Mewbourne, managing director at PIMCO. “The answer is that there will be years when equities are overpriced and years when central banks are raising rates. We think you have to be capital-structure agnostic and expand the opportunity-set.”
Again, this was the view taken by LCP. It was not only fear that managers might lean on their ‘neutral’ positions in periods of uncertainty that made it anxious to avoid index-weighted benchmarks. “As these economies and markets develop, our view is that the opportunity set will expand rapidly, so we want managers to be able to exploit those opportunities,” says Gibney.
That insight brings us to our second question about the advantages of bringing equity, bonds and currencies under the same mandate. Whereas the statistical argument for a ‘balanced’ approach is about longer-term diversification, the economic argument is more about tactical asset allocation and shorter-term relative-value decisions.
“A decade ago you followed your decision to be in emerging markets with an asset allocation decision that depended solely on the volatility you wanted,” says Sudeep Singh, manager of Matrix Group’s macro-style Matrix Redux Emerging Markets fund.
“Nowadays it makes perfect sense to be, say, short Brazilian equities, short duration and short USD/BRL.”
Similarly, Harting says that investors need to define their best ideas first and be agnostic about the securities they use to implement them efficiently. Its position in Qatar is a great example: it owns Commercial Bank of Qatar on a 10% dividend yield (undervalued because Qatar remains a frontier market for equity investors) and is able to buy sovereign CDS protection for 1% per year (because Qatar is a wealthy, AA-rated credit for debt investors).
Only a broad all-securities mandate could implement those kinds of positions. Every EM debt mandate is going to contain Brazil - even if its debt makes its equity market or its currency look like a bargain. And that issue of doubling-up with less efficient exposures to the same investment idea is just as relevant to corporate portfolios.
“If you have separate mandates you’ll find yourself with the debt, the equity and the convertibles in a company like Petrobras,” observes Singh. “Is that the best way to allocate capital?”
Frankie Tai, who manages Invesco’s Asia Balanced fund, doesn’t think so. He points out that a separate 50-stock equity portfolio and a separate 100-issue bond portfolio could easily add up to an over-diversified, 150-security emerging markets portfolio. But if both teams get bullish about Brazil, say, or industrials, there is equally a danger of over-concentration. “A one-team, integrated approach can mitigate against those risks,” he argues. Furthermore, he points out that his fund can be simultaneously positive on bank bonds but underweight bank equity, simply because regulation pushing higher capital ratios is credit-positive but depressive for return on equity.
Harting makes a similar point at individual capital structure level. He picks Gazprom as an example of a company whose strong balance sheet and cash flows make its debt look very good for a 6%-plus return. If you were a bond fund, you’d definitely hold it. But AllianceBernstein’s Multi-Asset fund holds only its equity: Harting feels that the debt is already pricing in those solid fundamentals, whereas the equity offers exposure to some upside while it trades at just five-times expected earnings.
By contrast, Mexico’s Cemex arguably looks good to an equity manager after the big refinancing that followed its disastrous pre-crisis expansion into the US’s frothiest construction markets. But that’s on a medium-term view. Long before anyone sees a dividend, bondholders can pick up a very nice yield, and multi-asset managers can choose their moment to rotate from one part of the capital structure to another. If, like the Calamos fund, you have a specialism in convertibles, the fact that Cemex is also a big convertible issuer opens up yet another avenue for exposure.
Not everyone talks up these opportunities. Philip Saunders, who has been researching EM as head of the multi-asset team at Investec, says that this kind of whole capital structure approach is “superficially appealing but fallacious” as long as corporate credit markets remain under-developed. Leading managers also argue for letting their bottom-up security pickers express their views freely. Indeed, Swabey makes the point that JPMAM can show potential clients a track record in emerging equities or bonds - but not one in making relative-value capital structure decisions.
“Our bond department will be looking at the Cemex corporate bond against the other corporate bonds in their universe; the equities would look at Cemex against other equities in their universe,” Swabey says. “My group makes an allocation decision between them, and would possibly intervene with a currency or CDS overlay if the aggregate position in Brazil, say, got to very high levels. Otherwise you could get quite muddled about why you were in one security and not another, between the group making asset allocation decisions and those making bottom-up decisions.”
Lazard, one of the firms selected by LCP, argues that the very fact that debt and equity have different risk profiles (so Cemex debt, say, behaves more like Petrobras debt than Cemex equity) makes the case for specialists rather than integrated relative-value players. In any case, Jacob observes, it might make perfect sense to regard the same company’s stocks and bonds as attractive at different levels for different reasons. Lazard’s aim is to combine its macro view efficiently with its team’s security-selection skills - but it sees little reason why this should not happen naturally most of the time.
“Look at Korea today,” says Jacob. “We have different views based on different theses built from different processes: a longer-term structural view on the won, but also CDS on the sovereign because that tends to be a very good risk-on/risk-off indicator, and equity from both ROE and a stable-growth perspectives. Overall, that’s a nice mix - a currency appreciation play, a stock-selection play and a macro hedge - but we end up with a fairly deep position in Korea - not because we started with a view that we wanted Korea, but because there are a range of good risk-reward opportunities in the country. You will find a similarly broad range of opportunities across many other countries.”
PIMCO takes a similar approach. If the same company is the top pick for both bond and equity managers, the multi-asset team might want to cut back on one or the other by reducing the allocation to the fund itself, or hedging the specific exposure at portfolio level. But there may also be portfolio-level objectives that differ from the bottom-up managers’ mandates - such as balancing overall equity, debt or currency exposures.
“It’s OK for both teams to like a company from their different places in the capital structure,” says Mewbourne. “But we do need to decide whether all of those bottom-up inputs have accomplished what we want. If we were not getting enough equity exposure, that may tilt the decision about how much debt or equity exposure we would take from an individual company. There are a lot of permutations.”
Gibney at LCP notes that some managers it consulted value the discretion to play different parts of a capital structure much more highly than others. “I do think it’s quite a powerful idea in regions where there is still inefficiency,” he says. “I wouldn’t necessarily agree that these opportunities are marginal, but even if they are marginal today, things are changing rapidly. Time will tell which is the best way to do this, but we’re quite agnostic and believe first and foremost that there needs to be a match-up between the strategy that the manager wants to run and the expertise and processes available to them.”
It is notable that two of the managers chosen by LCP, Barings and Lazard, both built their (very different) EM multi-asset strategies out of long pre-existing processes and expertise, but tend not to emphasise the capital structure relative value arguments.
What is clear, is that whether portfolios are fully integrated, or made up from two separate strategies overlaid with exposure management, either would mitigate unexamined double exposures or the unwanted diversification associated with simply awarding two or three separate mandates and rebalancing.
Can a single team claim the expertise to manage bottom-up across capital structures in emerging markets? Is there enough idiosyncratic risk even to enable such a thing? As Gibney suggests, these are fast-developing markets and this is a fast-developing strategic approach to them: for now it might make sense to hedge one’s bet and allocate to each of the two or three distinct multi-asset approaches that are multiplying on the horizon.