During the 1990s, the appetite for emerging market (EM) debt grew not only in volume, but also in the types of instruments traded, the number of trading houses involved, and the size of the market in relation to others worldwide.
Beyond the index: an unconstrained approach to EM debt
Institutional Portfolio Manager
Point of difference
EM debt offers an expanding opportunity set with plenty of diversification opportunities. What’s more, the diversity of the asset class should mean more attendant alpha opportunities for investors, but the changing nature of the performance drivers make alpha generation less straightforward than it seems.
“It is relatively easy to invest in emerging market debt through portfolios that track a major benchmark, like the JPMorgan Emerging Market Bond Index Global (EMBIG) for hard currency debt, the JPMorgan Government Bond Index-Emerging Markets (GBI-EM) (local currency debt), or the JPMorgan Corporate Emerging Market Bond Index (CEMBI).
“The challenge stems from the fact that while the benchmark-based strategies are common and straightforward approaches, they fall short of fully exploiting the potential of emerging-market debt, in our view. Going beyond the confines of benchmarks entails a greater level of expertise and commitment than most asset managers can provide, especially those principally involved in developed-market debt.
“So we would argue that the challenges of investing in emerging markets are not inherent in the asset class, but are a function of the asset manager’s capabilities,” says Murphy.
Looking ahead, there are several factors which could influence the asset class in 2018, including global economic growth, a rising US dollar, if the US Federal Reserve raises interest rates faster-than-expected, the rise of nationalism and geopolitical concerns.
Murphy says: “The geopolitical concerns that affect any broad asset class are generally going to also affect EM debt. The key difference is that emerging market local debt starts from an attractive valuation; no other asset class in the capital markets has this starting point.”
“What would adversely affect emerging market local debt would be if the Fed were to hike faster than the market expects.
“However, let’s say they hike four times but the market expects three, an additional 25 basis point isn’t going to be catastrophic for EM debt because it’s just the Fed moving a little faster than expected. This is in contrast to 2013 where the Fed just flat-out reversed course.
“Another thing to highlight here is that between 2004 and 2007 the Fed hiked 17 times and, in those three years, emerging market local debt was the best performing asset class relative to all other traditional fixed income,” says Murphy.
This distinct asset class continues to be a favoured area of fixed income with its high yields and value – it is still relatively cheap versus other global options. In addition to this, the emerging markets and developing economies have become increasingly important in the global economy.
They now account for more than 75% of global growth in output and consumption, almost double the share of just two decades ago, according to figures from the International Monetary Fund. On the downside, EM debt is perceived as quite risky by some asset managers and investors.
As a result some have become more defensive in light of recent gains and increasing political uncertainty, favouring shorter-duration bonds and adding dollar-denominated bonds.
Matt Murphy, institutional portfolio manager and vice president at Eaton Vance, says: “We believe the primary source of risk in EM debt is benchmark construction, because its country weightings frequently impose unintended risks and/or risks without sufficient upside potential. Asset allocation strategies, which rely on top-down, benchmark-constrained positions, share these characteristics.
“For example, dollar-dominated sovereign bonds have exposure to the US Treasury yield curve. Usually such exposure is unintended or undesirable, because it adds a developed market risk factor to the EM portfolio.
Similarly the performance of a number of eastern European currencies is highly correlated with the euro – another developed market factor that is usually unwanted.
“The structure of EM benchmarks works to compound such risks, because they are concentrated in larger issuers, which helps reduce diversification, increase volatility and inject developed-market risk factors into the EM portfolio.
Murphy says: “We believe that the risk inherent in this asset class is best managed through an index-unconstrained approach based on country-level macroeconomic and political research, and stand-alone analysis of specific risk factors. EM debt offers an attractive risk/return profile in a strategy that is effective at isolating desirable risks while mitigating those that are not.”
The Fund’s investment universe
Source: Eaton Vance & JPMorgan, 31/12/2017. Illustrative purposes only. Not meant to represent any Eaton Vance strategies.
Portfolio level considerations frame the suitability of investment positions, and performance accountability aligns with strategy objectives. This rigorous process provides Eaton Vance with the potential to deliver a portfolio with consistent outcomes.
Country analysis and access
Past performance is not a reliable indicator of future results. Source: Eaton Vance and Russell Investment Company. This information is for illustrative purposes only, is subject to change at any time and should not be considered investment advice, a recommendation to buy or sell any particular security or adopt any particular investment strategy. The information is based upon the total assets of all fee-paying discretionary accounts eligible for inclusion in the Emerging Markets Local Income Composite (the “Composite”) for the periods shown. Gross returns for the Composite are calculated in US dollars, include the reinvestment of distributions, and are after transaction costs, any foreign withholding taxes and other direct expenses, but before management fees, custody charges and other indirect expenses. This information is supplemental to the Composite’s fully compliant Global Investment Performance Standards (GIPS®) presentation which can be provided upon request by Eaton Vance. It is not possible to directly invest in an index.
Emerging Markets Local Income Composite:
Annualised Results as of 31/12/2017
The fund invests with a longer timeframe than many traditional managers.
The fund considers both private and public viewpoints, using as broad a range of
information sources as possible.
The fund uses all available liquidity sources.
The fund embraces logistical challenges as opportunities to invest where others will not or cannot.
The fund prepares for rapid changes in the political, economic, and/or regulatory
Eaton Vance Emerging Markets Local Income Fund
* Fund inception date 20 March 2015.
How the portfolio is constructed
Key Facts: Eaton Vance Emerging Markets Local Income Fund
TOTAL STRATEGY ASSETS: $696.7 million
STRATEGY INCEPTION DATE: 01/07/2007
FUND INCEPTION DATE: 01/02/2018
VEHICLE: Irish domiciled UCITS
BASE CURRENCY: USD
FEE STRUCTURE: 0.65% AMC with other expenses capped at 0.20%
What should pension funds think about when investing in EM debt?
Don’t try this at home! We’ve seen a lot of pension funds, in a prudent effort to reduce costs, bring emerging market local debt in house. But we think they need to take serious caution before doing so. Why? Well, each individual country has its own rules and regulations as regards trading their local debt and currencies, and it’s been our experience that a lot of pension funds will bring this in house and will not be able to use the liquidity sources that we have fostered over the last 20 years. They will likely not put in the time and effort to make sure they can exit some of these positions if need be because it requires significant resources.
A good example is Nigeria. Foreign investors in the country’s local capital markets need to have a certificate of currency importation when they bring capital into the country; and they need to provide that exact certificate of currency importation to the Central Bank in order to move money out of the country.
Nigeria was excluded from of the benchmark in late 2015 and it was our experience many investors did not properly operate within the local market regulations.
Therefore their capital was stuck in Nigeria while the currency depreciated over 35 percent through 2016.
The point here is that we applaud the desire to reduce costs by building EMD capabilities in-house, but investors need to be very careful when doing it in the local space because you might actually drastically increase your costs through suboptimal investment returns.
What countries and/or sectors look more attractive at the moment?
We are long local Serbian debt. We’re getting currency exposure and interest rate exposure in that market. Serbia is a country that’s growing, improving its rule of law and improving its business climate as measured by the World Bank’s business ranking. In fact Serbia has gone from 93 in the 2014 ranking up to 47 at the end of 2017. So it is a country that’s doing the correct things to attract capital.
It’s attracting foreign direct investment and that leads to currency appreciation. Serbia is also reducing inflation and that leads to falling interest rates. Therefore duration is a good thing to have. You contrast Serbia with what’s available in Central and Eastern Europe within the benchmark, and investors have a choice between three unattractive countries – Romania, Poland and Hungary.
In Romania there is runaway inflation and you have, at least from our perspective, a central bank that is behind the curve in tightening policy. In Poland the rule of law is being compromised to the point where the country might get ousted from the EU. And in Hungary the Prime Minister, Viktor Orban, is also compromising the country’s rule of law.
None of the debt from these three countries looks particularly attractive. Investors will own the debt because the benchmark tells them to own them but without a benchmark, would an investor really want to lend these countries capital in an absolute sense?
Our argument is no. Our argument is that investors should look to find countries with Serbia-like attributes.
What is your investment process?
JP Morgan lists 18 countries in the benchmark and accounts for about $900 billion worth of market capitalisation. Our investment process is unique in the emerging markets universe because we spend a lot of time taking risk beyond the benchmark. Our team has the ability to access 80 countries, not 18, and that leads to a total of around $2.25 trillion worth of market capitalisation.
So our investment process isn’t dependent on being better than our peers at investing in Brazil, for example, because that’s difficult to consistently do over the long term. Instead, our process is designed to use the entire universe and select positions with high Sharpe ratio ideas, rather than owning something simply because the benchmark tells us to.
To do this we take significant active risk, relative to our peers.
What is the Eaton Vance Emerging Markets Local Income Fund designed to do?
The Fund is designed to give investors a beta return of 1.0 to the JP Morgan GBI-EM Global Diversified benchmark and an additional 100 – 200 basis points of excess return. Ideally providing investors with market exposure they want for their portfolios in addition to excess return to justify the use of active management.
Our goal is to make the excess return fairly consistent. What that translates to is very high information ratios relative to our peers. The information ratio measures how volatile the alpha is, and our strategy’s alpha is relatively non-volatile. I think every manager says they want to provide excess return but our process delivers consistent and meaningful alpha regardless of the market environment.
MEET THE TEAM
Eric Stein, CFA Co-Director of Global Income
Eric Stein is a vice president of Eaton Vance Management, co-director of global income and portfolio manager in Eaton Vance’s global income group. He focuses on Asia, Western Europe and the Dollar Bloc. He also covers the policies and actions of the Federal Reserve and the U.S. Treasury.
Michael Cirami, CFA Co-Director of Global Income
Michael Cirami is a vice president of Eaton Vance Management, co-director of global income and portfolio manager on Eaton Vance’s global income team. Michael focuses on emerging Europe, the Middle East and Africa. He joined Eaton Vance in 2003.
Matthew F. Murphy, Jr., CFA, CAIA Institutional Portfolio Manager
Matthew Murphy is a vice president of Eaton Vance Management and an institutional portfolio manager on Eaton Vance’s global income team. He is responsible for covering global economic, political and market research. He also represents the global income team’s managed strategies and presents their views on macroeconomic and political developments in the world.
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Source of all data: Eaton Vance, JPMorgan, 31/03/2018, unless otherwise stated. This material is presented for informational and illustrative purposes only and should not be construed as investment advice, a recommendation to purchase or sell, or to adopt any particular investment strategy. This material has been prepared on the basis of publicly available information, internally developed data and other third party sources believed to be reliable, however, no assurances are provided and Eaton Vance has not sought to independently verify information taken from public and third party sources. Information contained in this material is current as of the date indicated and is subject to change at any time without notice. Future results may differ significantly from those stated, depending on factors such as changes in the financial markets or general economic conditions. Specific instruments, sectors and portfolio characteristics mentioned are included only to provide a snap-shot illustrative sample based upon the portfolio manager’s current investment strategy as of the date indicated. There is no assurance that any instruments or portfolio characteristics mentioned in this document are currently held or experienced in a portfolio or will remain in the portfolio at the time you receive this report or that instruments have not been sold or repurchased. The specific instruments mentioned are not representative of all the instruments purchased, sold or recommended for advisory clients. It should not be assumed that any of the instruments/sectors were or will be profitable, or that any recommendations in the future will be profitable or will equal the performance of the listed instruments. Actual portfolio holdings and performance will vary for each client. This is no guarantee that a particular client’s account will hold any, or all, or the instruments/ sectors mentioned. Not all of Eaton Vance’s recommendations have been or will be profitable. Changes in exchange rates may lead to fluctuations in the value of your investment. The strategies and views (if any) described may not be suitable for all investors. Investing entails risks and there can be no assurance that Eaton Vance, or its affiliates, will achieve profits or avoid incurring losses. It is not possible to directly invest in an index. Past performance is not a reliable indicator of future results. This material is issued by Eaton Vance Management (International) Limited (“EVMI”) who is authorised and regulated in the United Kingdom by the Financial Conduct Authority. This material does not constitute an offer or solicitation to invest in the strategy mentioned herein. Past performance is not a reliable indicator of future results. Investment return and principal value will fluctuate. Performance is for the stated time period only; due to market volatility, the strategy’s performance may be lower or higher than quoted. Composite data and other statistics are based upon the total assets of all fee-paying discretionary accounts eligible for inclusion in such Composite for the periods shown. Gross returns are calculated in US dollars and include the reinvestment of distributions, are after transactions costs, any non-US withholding taxes and other direct expenses, but before management fees, custody charges and other indirect expenses. Such fees and expenses would reduce the results shown.