new emerging market debt paper

The number of Blended EMD funds has trebled since 2009, while specific local or hard currency EMD funds have doubled. But implementation has proven challenging, benchmarks are highly inconsistent and performance comparison can be misleading

In emerging market debt, the use of local versus hard currency bonds has dictated performance over the past decade. This has helped to drive a dramatic increase in Blended EMD strategies. Mixed flows are at their highest ever level while, from a product perspective, the number of Blended EMD funds has trebled while the number of specific local and hard currency funds has doubled. JP Morgan has announced the launch of its first official Blended EMD benchmarks for 2018 – a significant step. Yet the purpose, practices and performance of these managers are not clearly understood. This is the focus of the latest Implementation Insight paper from bfinance, Emerging Market Debt: to Blend or Not to Blend.

EMD back in the spotlight

Emerging market debt has witnessed a dramatic return to favour in 2017, with flows even outstripping emerging market equity in a year when both have shown strong performance. Yet investors’ negative experiences in local currency EMD during recent years are colouring the picture. A closer look at the data shows a shift in appetite from local currency towards hard currency in 2009-12, and subsequently towards blended strategies that combine different EMD sub-sectors.

Local and hard currency EMD markets feature different risk exposures, characteristics, issuers and investor bases. Against hard currency sovereign debt, local currency bonds have offered stronger diversification potential than hard currency corporate bonds.

Dramatic increase in the number of types and EMD funds available 

There has been very rapid evolution in the EMD active manager universe (excluding hedge funds), with a far larger number of funds now available to investors. 2017 has also seen strategic shifts, such as a larger number of players beginning to define their focus in terms of differentiation between commodity-sensitive and less commodity-sensitive emerging markets.

Blended vehicles now accounting for approximately 60 funds, versus 20 in 2009. The hard currency and local currency sectors also offer more choice than in previous years, almost doubling over the same period. Standalone corporate EMD products meanwhile have exploded in number from 14 to 108, thanks in part to greater product segmentation in this area.


Performance analysis is particularly difficult in Blended EMD

Performance analysis is a significant challenge within blended emerging market debt. The wide variety of benchmarks and the presence of absolute return strategies (32%) make benchmark-relative performance analysis unfeasible. In addition, since managers have different strategic exposures to the sub-sectors, assessment based on sheer absolute performance can be very misleading. Track records do not provide a good barometer of manager quality.

It can be helpful to scrutinise sub-sector performance: the separate results in hard currency sovereign, hard currency corporate and local currency debt (security selection skill) can be detangled from the overall degree of exposure to each (asset allocation skill).

… while track records reveal strong results in risk reduction 

Blended EMD managers are not “shooting the lights out,” achieving only modest excess returns against various benchmarks. Yet they have proven successful at reducing risk, losing out on some upside but avoiding a significant amount of downside. Substantial use of derivatives is an important contributor to results, particularly in local currency markets.

Few managers are “super-allocators,” with most using a bottom-up approach

Do blended EMD managers provide an effective way of outsourcing the asset allocation decisions for the different EMD sub-sectors? Investors seeking a “super-allocator” to swing tactically between local, hard and corporate markets may be disappointed.

For most, sector exposure is primarily the end-result of country and instrument selection. This may or may not produce significant variations in high-level sector allocations. For approximately half of Blended EMD managers, the difference between the minimum and maximum exposure to local currency EMD over three years was less than 20%.

bfinance finds that there is not one inherently superior approach: what is more important is that the team structure is aligned with the investment process.

Mathias Neidert, Managing Director and Head of Public Markets said: “We have seen a very significant increase in emerging market debt searches in 2017, much of which has been directed towards blended strategies. With the trend appearing likely to continue, this seemed to be an opportune time to share some detailed scrutiny of the Blended EMD sub-sector.

“It is a remarkably difficult area for performance analysis: On one hand there are plenty of absolute return strategies without any benchmark in this space so that benchmark-relative analysis on an outperformance basis is impossible; on the other hand strategies have different strategic exposures to local currencies making an assessment purely based on absolute performance misleading.

“Only a minority of managers in this space are doing what I would call true top-down tactical allocation for local currency, hard currency and (where relevant) corporate debt: most are taking a bottom-up approach and, in a lot of cases, these weightings aren’t changing a great deal through time.”

Aramide Ogunlana, Associate, said: “One interesting aspect of these managers’ results is that they really have proven to be very good at reducing risk against various benchmarks, capturing less of the upside in months where returns are positive but giving significant protection on the downside. They are not shooting the lights out with their returns, but they are reducing volatility.”

Kathryn Saklatvala, Director of Investment Content, commented: “We hope that this report provides investors with useful insight on a rapidly evolving and somewhat opaque segment of the EMD universe. In addition, the “DNA of a Manager Search” section shows that fees are open to a very significant degree of negotiation.