EMD Relative weekly notes: Week Ending April 12, 2019
We view this blog as much more of an educational tool for an asset class, perhaps the least well understood in global fixed income, than an advocacy device meant to suggest that the near term future for EMD is always so bright you have to wear shades. In that spirit, this week's lesson is quick and specific: Are passive flows an indicator of future results and something to focus on for investors? No, they are not.
Passive funds have exploded in EMD just like everywhere else, with the largest fund that has by far most of the market share growing from a few billion five years ago to currently near $17 billion. However, the high trading costs associated with vehicles that are price insensitive make them poor vehicles for strategic allocations—particularly in an asset class where excess returns are available. So it is widely acknowledged they are used to gain market exposure quickly and tactically. In that role, they are doing a poor job.
Figure 1 shows why. The white line represents the AUM of the EMB fund, by far the largest EMD ETF. The green line is the inverted spread-over-treasuries of the sovereign dollar index. February 2018 marked a low in those spreads and they widened from that point as the US dollar and the risk-free rate rose. Consistent with this, EMB assets bottomed in May of last year but then rose steadily until November—as spreads continued to rise and investors experienced a year of negative returns. In December, EMB assets fell sharply and spreads rose by about 20 basis points, yet a treasury rally resulted in a 1.46% gain for the index.
Source: Bloomberg. Chart depicts the JPMorgan USD Emerging Markets Bond ETF (“EMB”) in white and the JPGCSOSD Index (EMD dollar sovereigns spreads to US Treasuries) in green from January 1, 2018 through April 11, 2019. Performance shown reflects past performance, which is no guarantee of future results. Actual results will differ from index results.
Only in January do we see a correlation arising, but since February assets have dripped lower while spreads have remained steady—and dollar EMD investors have had positive returns in every month of 2019 so far including the current one.
This week's $482 million fall in assets has garnered some press attention, as it is the biggest since the February 2018 drop. But it is no harbinger of spread movements or returns that investors should anticipate. There are a multiplicity of drivers of this asset class--treasury moves, the US dollar trajectory, risk-free rates forecasts, and liquidity into or out of the asset class in the form of FX reserves—are some of the most important. In our opinion, the activity of passive investors is not one of them.