This article is part of NordSIP Insights – Investing Sustainably in Emerging Markets Read or Download the entire publication here.
by Barney Goodchild, Investment Director Aviva Investors and Aaron Grehan Deputy Head of Emerging Market Debt and Portfolio Manager, EM Hard Currency Aviva Investors
Emerging market debt (EMD) can offer significant returns, but has historically been susceptible to periods of increased volatility and rapid spread widening, as recently witnessed during the initial economic and market fallout from the COVID-19 pandemic. During these periods, many active managers struggle to outperform their benchmarks. As shown below, when the JP Morgan EMBI Global Index declined 4.6 per cent in 2018, 66 per cent of managers underperformed. Similarly, when the index fell 1.9 per cent in the first six months of 2020, more than 70 per cent of managers lagged the index.
An analogous pattern emerges when we look at significant monthly drawdowns. In one of the most turbulent months during the global financial crisis, October 2008, the index fell 14.9 per cent and 82 per cent of managers underperformed. More recently, 94 per cent of managers underperformed when the benchmark declined 12.6 per cent in March this year as the economic impact of strict lockdown measures became clear* (Source: eVestment Global Emerging Market Debt Hard Currency Universe).
We believe there are three main reasons many managers fail to outperform during periods of market weakness:
- A structural bias towards the higher-yielding parts of the EMD market;
- A poor understanding of EM-specific risk factors and overreliance on traditional risk metrics;
- Deficiencies in portfolio construction that leads to concentrated portfolios and overreliance on credit spread compression.
A failure to fully consider these factors is likely to lead to higher drawdowns and increased volatility of excess returns over the long run. In this article, we examine the key elements of our approach to investing in EMD, which we believe are crucial to delivering superior outcomes for clients. These include uncorrelated alpha, a smoother return path and robust portfolio construction to drive consistent outperformance.
A differentiated approach to emerging market debt
Emerging markets are typically less efficient than their developed market counterparts. In our view, alpha opportunities are created by the breadth and diversity of an under-researched and under-reported universe. Our approach to generating consistent outperformance in this market is underpinned by the three core pillars detailed below.
Unbiased, flexible process to generate uncorrelated alpha
The EM hard-currency debt universe is split approximately 60/40 between investment-grade and high-yield issuers. Our analysis of the EMD hard-currency peer universe suggests most managers have a structural bias towards higher-yielding parts of the market.
Whilst this can be profitable at certain points in the cycle, over the long run it is likely to lead to higher drawdowns and increased volatility of returns. Periods like Q4 2018 and Q1 2020 are particularly good examples of when a high-beta approach to the asset class can be costly.
We take a different approach. We believe attractive investment opportunities exist across the investable universe, not only within the higher-yielding parts of the market. Our approach considers the full opportunity set without bias, resulting in flexible positioning between the high-yield and investment-grade portions of the market.
The result: Alpha generation that has historically been uncorrelated to spread differentials between high yield and investment grade.
Ultimately, our ability to generate alpha is less dependent on high yield spread compression. We generate alpha from active country selection decisions, not broad-based beta allocations.
Deep understanding of EMD risk fosters capital preservation and smooth return path
As an asset class, EMD offers potentially attractive returns; however, different markets can exhibit periods of high volatility and idiosyncratic risk that are difficult to capture within traditional risk measures.
Tracking error is one such example. The measure is widely used by portfolio managers and Investment managers to understand the levels of risk within a portfolio. However, it has several serious limitations that we believe make it a poor risk metric:
Fails to measure risk of loss: Tracking error measures the deviation from a benchmark rather than the risk of loss. If a benchmark index is inefficient, deviations from the benchmark should be beneficial by reducing risk or improving portfolio returns. Too often, however, deviation from a benchmark is viewed as “taking risk” rather than reducing it or improving risk-adjusted returns.
Engenders forced ownership: Investment Managers and consultants often focus on tracking error as a measure of the degree to which a portfolio is active. Strategies with low historical levels of tracking error are often labeled as “closet trackers” or “semi-passive.” This forces managers to add risk or off-benchmark positions as a means to appear sufficiently active.
Incorrectly assumes more risk leads to excess returns: In some asset classes, such as US investment-grade credit, a strong correlation exists between tracking error and excess returns. This suggests that adding risk on average improves manager returns. Our analysis, however, indicates there is no correlation between tracking error and excess returns for EMD hard-currency managers. This is likely to be the result of higher downside risks.
We focus on variety of risk measures, such as duration times spread, alongside a deep understanding of EM-specific risks built over decades of experience. Our process is not predicated upon a foundation of imperfect metrics. We believe this is a critical differentiating factor in our ability to deliver superior client outcomes. It is also important to consider non-financial risks, such as environmental, social and governance factors. These can highlight risks and opportunities that would not be captured by quantitative risk metrics or traditional fundamental analysis.
An in-depth understanding of EM risk is embedded throughout our investment process, which is centered around fundamental analysis. Through this, we believe we are able to thoroughly assess an issuer’s risks to determine if we will be compensated accordingly.
We draw on a blend of quantitative and qualitative analysis to assess an issuer’s ability and willingness to repay debt, their vulnerability to external shocks, and the ability of the authorities to take appropriate action if required.
Focused portfolio construction can drive consistent outperformance
Robust portfolio construction is essential to transforming good ideas into portfolios that meet clients’ risk and return objectives, as well as constraints. Our process is focused on maximising risk-adjusted returns rather than total returns. We target the most attractive opportunities irrespective of credit rating.
In order to build a high-conviction portfolio, we are benchmark agnostic at the issuer level, which allows us to concentrate on countries that are meaningful from a risk/reward perspective at the total portfolio level. While the EMBI Global universe is defined by 74 countries, as at 30 June 2020, the portfolio will typically have exposure to only around two-thirds of that total, with 15-20 positions driving risk contributions at a portfolio level.
To help strike the right balance between long-term and short-term opportunities, we break down the portfolio into core, active and tactical positions. This seeks to ensure capital is allocated to credits that offer improving prospects across a diversified universe with an appropriate blend of opportunities to maximise risk-adjusted return.
To recap, we believe there are three main reasons many managers fail to outperform in periods of market weakness:
- A structural bias towards the higher-yielding parts of the EMD market;
- A poor understanding of EM-specific risk factors; overreliance on traditional risk metrics;
- Deficient portfolio construction that leads to concentrated portfolios and overreliance on credit spread compression.
By understanding and correcting for the biases and pitfalls, we believe we can deliver:
- Alpha generation that is uncorrelated to spread differentials between high yield and investment grade;
- Enhanced capital preservation and a smoother path of returns versus peers and the benchmark;
- A differentiated process that can generate positive excess returns throughout market cycles without being overly reliant on a single source of alpha, such as credit beta.
For more information, download the whitepaper ‘An unbiased approach to finding opportunities in emerging market debt’.
Contact Peik Wardi, Head of Nordics Institutional at Aviva InvestorsTel +358 400 804 458. [email protected]
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Investments can be made in emerging markets. These markets may be volatile and carry higher risk than developed markets. Bond values are affected by changes in interest rates and the bond issuer’s creditworthiness.
Bonds that offer the potential for a higher income typically have a greater risk of default. Investments can be made in derivatives, which can be complex and highly volatile. Derivatives may not perform as expected, meaning significant losses may be incurred.
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