A Call for Truth in Labeling in Emerging Market Debt
The emerging market debt (“EM debt” or “EMD”) asset class has matured greatly since its first index was created in the early 1990s. Predominantly non-investment grade at inception, EMD hard currency sovereign indexes are now approximately 50% investment grade. Generally speaking, emerging countries now are growing faster and carry less overall debt than their developed counterparts. Moreover, the policy prescriptions these countries introduce are largely orthodox, and their willingness to adapt fiscal policies to align with current economic realities in many ways exceeds that of developed countries.
Representing approximately 15% of the world’s bond market capitalization (source: JPMorgan), it’s clear that EMD has arrived as a core asset class. When examining the approaches money managers employ in this asset class, however, the benchmarks selected often bear little resemblance to what is actually occurring within the portfolios themselves. This can raise incorrect investor expectations, and lead them to invest in EMD strategies that do not meet the specific needs of their fixed income portfolio. We believe that truth in labeling needs to become a focus among EMD managers so that investors can be better matched with strategies that meet their particular needs.
The EMD universe is comprised of distinct sub-components with different principal drivers of return in addition to their basic fundamentals:
- Hard currency EM sovereign – US treasury yields
- Hard currency EM corporate – Overall credit cycle
- Local currency EM sovereign – Path of the US dollar
The principal EMD benchmark, JPMorgan EMBI Global, measures hard currency sovereign bonds, and has been in existence nearly 25 years. The vast majority of money in this asset class is benchmarked against it. This is the case even though an examination of typical EMD portfolios shows that the breadth of underlying investments is far wider than just hard currency sovereigns. Nowadays it is quite common for managers to list JPMorgan EMBI Global as their underlying benchmark yet to invest liberally in hard currency corporates, local currency sovereigns, and local currencies as well. These off-benchmark bets may not have been a major issue when they were smaller in stature or when EMD was a more homogeneous asset class. Today, however, it is not uncommon for an EMD manager benchmarked to JPMorgan EMBI Global to invest in excess of 20% in issues that are not hard currency sovereigns and are, therefore, off-benchmark bets.
This creates a series of unintended issues for investors, which may not be resolvable:
- Uncertainty as to the primary risk drivers of the underlying portfolio
- Ambiguity as to the expected level of volatility and corresponding return
- Less certainty about how an EMD allocation will fit into a broader investment portfolio
The chart below contains a series of more than 30 wide-ranging EMD funds (totaling more than US$74 billion) that are benchmarked against either the JPMorgan EMBI Global or EMBI Global Diversified indexes. Their most recent portfolio allocations are presented. One would expect to see very high allocations to hard currency sovereign and very low percentages in the other columns given that they are explicitly naming a hard currency sovereign benchmark.
Source: Schroders and various investment company websites, from a fund universe of 343 funds. Data as of March 31, 2017. Excludes ETFs. Includes US- and Luxembourg-domiciled mutual funds benchmarked to either index. Actual investment objective for funds vary, and each underlying investment approach may permit the use of non-benchmark securities, or varying degrees. Portfolio composition is subject to change over time.
The reality is quite different. Consider the following:
- 74% (23 of 31) of those we selected employ more than 10% away from hard currency sovereign issues
- The average off-benchmark bet for the entire peer group was a robust 22%
- For those managers who delve into corporate issues, the average allocation was nearly 15%
- A cursory examination of the allocations, in our view, suggests that a more accurate benchmark for the collective peer group could plausibly be 80% hard currency sovereign, 15% hard currency corporate, and 5% local currency sovereign.
The off-benchmark move into EM corporate bonds is particularly notable, as they carry fundamentally different credit risk and liquidity profiles than sovereign bonds. We also have tracked the recent allocations to Venezuelan sovereign debt. More than half the peer group (16 of 31) holds allocations of greater than 3%. We can understand why some managers may want to maintain a benchmark-like allocation (2% to 3%) to this sovereign issue since it is an index component. Still, we would be surprised if investors understood the heightened level at which some managers are willing to invest in this teetering credit.
It is not our position that investing in a broader swath of EMD is a bad thing – quite the opposite. There is a strong case to be made that investors should participate in all sectors of EMD in an effort to maximize risk-adjusted return. For example, the flexibility of a multi-sector approach can be helpful in order to take advantage of the changing return opportunities.
The chart below lists the performance of the individual sub-components of EMD for the past 10 calendar years. Aside from the obvious temporal movement, consider that in seven of these 10 years the dispersion between the highest and lowest performing sub-component was greater than 8%. Such performance dispersion provides an excellent opportunity for a skillful portfolio team to shade the portfolio in order take advantage of these market openings.
Source: JPMorgan and Bloomberg.
Sovereigns are represented by the JPMorgan EMBI Global Diversified Index; Corporates are represented by the JPMorgan CEMBI Broad Diversified Index and Local Currency is represented by the JPMorgan GBI-EM Global Diversified Index. Past performance is no guarantee of future results. Actual results will vary.
At 18% of global fixed income market capitalization (source: BAML, June 2017), the EMD asset class has reached a level of maturity where it deserves consideration for an allocation within most fixed income portfolios – in our opinion – due to its breadth and underlying liquidity. This is particularly the case in a world starved for current yield. As with all asset classes which reach a certain level of maturity, however, we believe the investment method employed by a relative return manager must be measured against a benchmark that is an accurate reflection of opportunity set being employed. Employing a sovereign hard currency EMD benchmark while the underlying investments are far afield is hardly a transparent approach appropriate for the underlying investors. EMD benchmarks which are comprised of various allocations of the opportunity set employed would allow investors to better gauge the performance of their EMD managers.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.