Building a ship to withstand the storms

Nick Cooney

Senior Consultant

The bottom line:

Finding good active EMD managers is challenging. Investors should get a strategy in place now to strike when a tactical opportunity presents itself.

Optimising EMD allocations

EMD - Emerging market debt describes borrowing by either emerging markets governments or companies. Compared with its developed market equivalent, EMD is perceived as riskier and therefore typically offers higher prospective returns.

Why should you care about EMD?

Before we set sail, I start by mapping out why you should take an interest in this topic. EMD represents one of the largest and fastest growing fixed income opportunities available to investors over the long-term, particularly within corporate bonds and local currency markets.

For context, it is estimated that EMD currently accounts for 25% of all debt issued on global bond markets.

However, despite this, the majority of institutional investors are likely to have under-weight exposure or possibly no exposure whatsoever. Indeed, EMD has this year experienced the most dramatic outflows seen in the past 17 years.

Significant headwinds from inflation, recession, geopolitics and the increasingly attractive relative value on offer in developed markets have reduced the tactical attractiveness of EMD in the short run. Others may quite rightly have ESG-related concerns; for example, some may hesitate to allocate to countries like China, accused as it is of overburdening some other countries with debt and oppressing its own minorities. However, while it's fair to say that EMD as an asset class faces its fair share of challenges, my view is that the current stormy outlook will in time clear. The sun rises in the east. We believe that investors should weigh anchor and be prepared to leave harbour quickly when the time comes.

The apparent caution or reluctance to explore EMD is greater for UK than it is for other European investors. Within the latest update to the LCP strategic portfolio, we advise that around 12% of investor’s allocation to high return credit be assigned to EMD. Sub-asset classes within EMD have different characteristics, so we generally prefer a blended approach for most investors.

Spread is the extra yield demanded by investors to compensate for higher default risk and lower liqudity, relative to equivalent risk-free alternatives.

While some investors may have indirect exposure to EMD via diversified growth funds (DGFs) or multi-asset credit funds (MACs), the majority of these products also have relatively muted exposure. Indeed, many pooled MAC products marketed in Europe have explicit restrictions against EMD holdings, something we have broadly supported given the specialist skill set required to manage this historically volatile sector.

Being a large asset class is, of course, no reason to justify exposure, not least considering EMD is experiencing one of its worst years on record. The most obvious merits are the persistently higher yields available compared to equivalent rated developed market bonds and the diversification benefits derived from both a wider opportunity set and divergent correlation profiles. Most investors don’t hold much EMD at the moment. My view is that they should hold substantially more in the future.

Active vs passive

EMD is an inherently complex, intricate, and nuanced asset class. In my opinion, active approaches are superior when investing in EMD, particularly for those looking to mitigate downside risks

EMD drawdown history

Source: Morningstar Bloomberg

Perhaps surprisingly passive approaches often fail to deliver index returns. ETFs, a bastion of passive investment are an intriguing case study that help unravel the fallacy that passive performance is synonymous with benchmark performance. The reasons for this are predominantly the frequently significant broker fees, illiquidity, custody and tax charges levied in many emerging jurisdictions which make implementation of a benchmark more challenging than in developed markets.

I would also argue that EMD benchmark construction is flawed and inadequately represents the investible universe. Within local currency markets these issues are more pronounced, with some estimates suggesting that popular indices only represent around 10% of the actual asset class and structural restrictions significantly distort outcomes. It seems unimaginable for example that a similar developed market index would restrict US exposure to 10%, whereas this is exactly what happens to large countries like China within emerging markets (I’m not going to address ethical debates at this stage). Flawed indices inevitably reduce analyst coverage and market efficiency, and in doing so create opportunities for active management. Determining the optimal approach to active management, however, is an even greater challenge.

Time series data analysis

Legendary British sailor Sir Robin Knox-Johnston once said that “whatever you do in life there are always people who take a delight in telling you you’re wrong”. In the world of asset management, these cynics are better known as manager researchers, and we do indeed at times take a rather grim satisfaction in identifying problems. By extension however, the implication of this is that there exists a ‘correct’ or at least better way of doing things.

In EMD we have not found this to be the case – on testing some of the core 'differentiators' or styles highlighted by managers we find a distinct lack of statistically significant evidence to support the idea that a certain approach to EMD consistently outperforms over different time periods.

Commonly quoted differentiators

We have a very large team dedicated to EMD analysis
We have teams on the ground in several developing markets
We all work from one office, which allows better idea sharing
We are unconstrained and able to take advantage of 'off-benchmark' positions
We have a highly diversified portfolio
We have a concentrated portfolio of only the best ideas

We carried out statistical analysis on blended EMD strategies from a sample of asset managers who collectively invest around £300bn in the asset class. This project investigated whether the various differentiators and ideologies expressed by managers had any meaningful, repeatable impact on performance outcomes.

For example, one might expect managers with a larger team to outperform using the simple rationale that they are better able to explore the vast ocean and identify attractive opportunities. However, our study found little evidence suggesting that managers possessing a bigger crew or located in more destinations had any performance advantage over smaller managers working collegiately out of a single port. Nor did we find proof that the returns from higher conviction, total return or benchmark agnostic portfolios consistently beat those that are more diversified or ‘benchmark aware’. The fact that the tide can turn on one style influences our preference for blending EMD allocations and selecting multiple managers if governance allows.

This does not however render careful selection a futile endeavour. While it is a myth that a single active EMD approach rules the waves, there are managers out there that we believe stand a greater chance of outperformance over time. Regrettably, blunt screening alone is insufficient to locate them and we need to dig deeper in order to find the buried treasure.