Traditional perceptions of how to access emerging market debt are shifting as this asset class undergoes rapid evolution.
In the past, adopting an active management approach was perceived as one of the best ways to invest in this asset class. This was based on the assumption that the market is inefficient and that detailed fundamental knowledge should enable active managers to extract value. There was also the prevalent assumption that indexing will mean exposure to some obvious ‘weak’ segment that could drag performance down.
The reality is quite different. Emerging market debt now offers greater liquidity, while the majority of active managers fail to outperform their benchmarks over the longer term.
A large, diverse and liquid universe
The emerging market debt universe has grown dramatically over the past decade and the types of securities on offer have become much more diverse.
Our analysis focused on the investible universe, based on the indices most followed by institutional investors. Based on our estimates, this universe stood at $4.9 trillion (Dh18tn) at the end of March 2018.
To put this in context, this is almost twice the size of the global high yield market, which is often seen as a more traditional growth asset for fixed income investors. While the increase in market size has been well documented, the fact that emerging market debt liquidity is now on par with investment grade credit is less widely known.
Active vs. passive emerging market debt
We have carried out a comprehensive study of the active managers in the Morningstar database that track two flagship EMD indices: JPM GBI-EM Global Diversified Index (GBI-EM) for local currency and JPM EMBI Global Diversified Index (EMBI) for hard currency. What we found is that, in both local and hard currency debt, while some active managers outperform their benchmarks, the majority have failed to do so over the longer term.
Our research does not support the idea that bottom-up, fundamentally-driven active approaches provide meaningful downside protection.
We looked at six instances of significant negative return events in recent years driven by individual or multiple countries. In general, they were the result of a number of factors, including a sharply deteriorating economic outlook, political instability and debt restructuring. Some were perhaps easier to foresee (Venezuela, Ukraine) while others were more left-field (Russia, Brazil). Based on a recent Morningstar analysis, even the top 20 managers were unable to outperform the index during these country-driven events.
Why active managers struggle to outperform
The inherently ‘high-octane’ nature of emerging market debt is likely to be one of the key causes of active manager underperformance. Returns are often misaligned with fundamentals, as they are driven by investor sentiment and political risk, which are harder to predict and often lead to binary outcomes.
In hard currency debt, performance is often driven by high yield names in the index, as the investment grade names are already fairly priced. Importantly, it is often distressed names that determine a manger’s relative performance. For example, in recent years, making the right calls on situations such as Argentina’s litigation with holdout creditors, Ukraine’s restructuring or Venezuela’s willingness and ability to meet its debt obligations have been key to active manager performance. While many of these countries are only a small part of the index, under- or over-weighting them makes a big difference in performance, due to their high yield and the volatility of their returns.
By definition, these names are fundamentally weak and if a manager is driven by a quality-focused approach, they may miss the potential for sudden revivals.
For instance, Venezuela has been thought of as a “basket case” for years, amid an ever-worsening political and economic backdrop, but only announced a debt restructuring at the end of 2017. The year before that, it actually delivered a staggering return of 53 per cent. Had investors been under-weighting the country, they would have incurred a significant underperformance record. The many binary decisions active managers must take in the hard currency space may partly explain why they consistently struggle to outperform.
In local currency debt, the performance drivers are different: foreign exchange matters in the short term and local rates in the long term. Emerging market currencies are typically the main adjustment valve to reflect market sentiment, which means that making the right call, especially in times of heightened market volatility, is particularly difficult.
In conclusion
Over the last 15 years, the emerging market debt sector has been transformed in terms of size, liquidity and security type and the majority of active managers have consistently struggled with the mercurial nature of emerging market debt. Cost-efficient and transparent index approaches are now seen as highly effective and are gaining popularity among institutional investors.
In the future, as emerging economies evolve, emerging market bond exposures may become a core part of investors’ fixed income portfolios. However, decisions as to what exposure to take and via which investing style will be paramount in determining whether the full potential benefits are realised.
Niall O'Leary is Global Head of Fixed Income Portfolio Strategists at State Street Global Advisors, which is a member of The Gulf Bond and Sukuk Association. Lyubka Dushanova, portfolio specialist for fixed income, and Emmanuel Laurina, managing director, head of Middle East & Africa for SSGA, contributed research
