Holistic approaches to EM debt exposure
Asset allocation is key to successful investment in emerging markets. But the real task is working out how best to invest among the wide range of assets and strategies available, according to Joseph Mariathasan
The case for emerging markets may be clear-cut but for many investors the key decision is how best to invest, given the range of assets available. Debt alternatives include hard-currency sovereign debt, hard-currency corporate debt and local-currency sovereign debt. A newer possibility, rapidly increasing in size and importance, is offered by the localcurrency corporate debt markets. Investors also need to consider index-linked debt and currency exposures.
At a glance
• Asset allocation is key.
• Emerging market sub classes respond to different economic factors.
• Benchmarks exist for debt-only and for debt-plus-equity.
• Multi-asset strategies often aim to beat equities with lower volatility.
• Top-down, bottom-up, factor-driven or combinations?
Not surprisingly, some investors reach the conclusion that asset allocation within emerging markets including equities should be best left to their investment managers. Sergio Trigo Paz, the head of emerging market debt (EMD) at BlackRock, says: “When all markets were doing well with double-digit returns, asset allocation did not matter. After the 2013 taper tantrum, when the then Fed chairman Ben Bernanke’s hint of a tapering of QE [quantitative easing] purchases led to a dramatic fallout in emerging markets, sophisticated institutional investors such as the Scandinavians gave up on asset allocation and outsourced it to the managers.”
It is clear that asset allocation is key to successful investment in emerging markets. How to achieve good results is less straightforward. Diversification may be seen as a clear objective of multi-asset approaches but taken on its own it has to be treated with care. “The problem with diversification in emerging markets is that a lot of asset classes tend to be highly correlated,” says Gerardo Rodriguez, the head of emerging markets multi-asset strategies at BlackRock. “Hard-currency bonds have a credit component and both credit and currencies tend to move with equities so the correlation between equities and hard-currency fixed-income can be as high as 70%.”
But as Grant Webster, a portfolio manager at Investec Asset Management, argues, the value lies in the fact that not all of these asset classes will react in the same way in the same economic environments: “For example, in a strong growth environment currencies, corporate debt and dollar sovereign debt may perform well while local-currency local debt may suffer from rising inflation and interest rates,” Webster says.
There is no simple right answer for the best approach but the fact that more managers seem to be launching multi-asset emerging market strategies indicates that there is demand. Rodriguez identifies three types of investors to which these strategies can appeal.
First, there are those looking for a one-stop solution to gain exposure as they are overwhelmed by the complexity of emerging markets. As Webster says, such investors may not have the governance capacity to make asset allocation decisions between debt and equity. Adding equities and infrastructure allows the manager to increase the risk by allocating more to equities during cyclically attractive periods.
Second, there are investors who have emerging market equity exposure but are not comfortable with the 25% annualised volatility and so are looking for alternatives to equities, with similar returns but lower volatility.
Third, are the most sophisticated institutional investors who try and analyse the risk factors in both developed and emerging markets.
Multi-asset emerging market strategies vary. At one end of the spectrum are fund-of-fund approaches where each asset class is managed in separate funds. At the other extreme are bottom-up approaches where managers pick the various individual stock, bond and currency holdings with no regard for the overall asset allocation mix.
Fund-of-fund approaches often aim to achieve equity-like returns but with lower volatility by allocating to EMD in a judicious manner. As Sandra Crowl, a member of the investment committee at Carmignac Gestion, says, deciding how much exposure to have to equities at any one time is key. The firm has a 50/50 equity bond benchmark, but is currently defensively positioned with only a 40% equity exposure. That is concentrated in companies with high earnings potential, low debt and solid free cash flow. “Should growth pick up, it won’t be as important to have all three criteria in our stock selection,” notes Crowl. The split between hard currency and local currency is then decided on a top-down basis. Factors such as valuations and fund flows are key.
The mix has shifted from an 85% hard-currency exposure in mid-2014 to a 40% exposure in mid-2015: “Local-currency debt is particularly attractive in certain countries with high real interest rates, curve-flattening potential, low US dollar debt and with current-account surpluses,” continues Crowl. “These attributes lead to stable currencies and a positive economic environment which limits contagion from political stress, such as that posed by Greece, or correlation with rising US interest rates.”
AllianceBernstein’s strategy also targets equity market returns but aims for two thirds of the volatility. Its equity component can vary from a low of 50% to over 90%, says Marco Santamaria, co-head of the emerging markets multi-asset team. Its approach uses a mixture of quantitative modelling of returns and correlations combined with qualitative input from the portfolio managers.
The AllianceBernstein fund has a 60% exposure to emerging market equities at present and another almost 7% investment in developed market equities with a high emerging market exposure. The rest is in EMD, predominantly hard currency. Santamaria says: “Fixed income has two roles. Firstly, to diversify away some equity risk by using long-duration EM bonds that have a high sensitivity to US interest rates as that does diversify equity risk.
“Secondly, to find debt with equity-type returns such as hard-currency, high-yield and local-currency debt and foreign exchange. We are currently adopting a defensive stance, so the primary purpose of debt is to provide US dollar duration to provide downside protection against a possible equity market sell-off.”
BlackRock has recently investigated the possibility of a top-down approach that, rather than focusing on asset classes, tries to look at the underlying risk factors that drive returns in emerging markets. Rodriguez identifies three factors as important in that respect. First, the growth of equity asset classes. That is in traditional emerging market and frontier markets, as well as some developed market companies with high emerging market exposures and also some credit, all of which do well when growth does well.
Second, is the interest rate component in emerging markets. Higher credit quality bonds behave more like developed market fixed income, for example, and the same applies to local-currency debt if the currency component is excluded. This element performs well when GDP growth is low, while the correlation behaviour tends to be different between stable countries such as Thailand and risk on/risk off countries such as Brazil and Turkey.
Finally, there are pure relative value long/short strategies. These include value, growth, momentum in the equity space or absolute return strategies in fixed income.
Pure bottom-up approaches are less common but Ashmore is an exponent. Jan Dehn, the firm’s head of research, says: “We are a value investor and rank all opportunities on a view of fair value. We then allocate across opportunities according to size.” For equities, the analysis is based on factors such as a company’s earnings potential, its growth prospects, and its technical characteristics.
In the fixed-income markets, Ashmore needs to introduce a view on currencies to be able to compare hard-currency and local-currency debt. Dehn sees three components of value. The first is relative prices. For example, if the price to earnings ratio in China is three and local-currency bond yields are low as well, then equities would be viewed as cheap and bonds as expensive. The other two components are the underlying fundamentals and the global environment.
Dehn argues that most of the volatility in emerging market assets is the result of global markets, as well as instability and currencies in developed markets. “Very little of emerging market volatility is attributable to emerging markets,” he says. What he means is that there are competing opportunities between equities and debt with the strategy currently only having a 20% equity exposure.
“We are likely to underperform in two situations,” Dehn continues. “Firstly, a bubble, often driven by leverage, when we can’t reconcile values and prices – for example, in China A shares. Secondly, when the market is overly bearish. For example, in the fourth quarter of 2014 we added to Russia when yields were 700bps over US Treasuries, which was a complete mispricing based on the geopolitics, the oil price shock and other factors. But the economy is strong, so no more incremental risk was justified. We kept buying Russia as the market was falling. In Q1 2015, the bonds rallied to 300bp spreads and we sold.”
Between the extremes of top-down fund-of-fund approaches and purely bottom-up lie many other possibilities. For example, Investec’s blended approach combines the two by first dynamically making allocations to the various asset classes, and then building up those allocations using their best bottom-up ideas.
For institutional investors who see emerging markets as having attractive long-term potential but representing a complex set of risks and opportunities, outsourcing asset allocation to fund managers is clearly an attractive option. Deciding on which approach is most suitable is probably more dependent on the preferences of the investor than on any theoretical framework.