Emerging Local Markets | Foundation interview

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  • 10 mins 19 secs
What does EM Local do that hard currency debt doesn't? What does it mean to be active in EM Local? How do you view an active approach versus a passive one? T. Rowe Price's portfolio manager joins us to discuss.


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The emerging market local currency debt asset class is suitable for a broad range of investors. The tendency or the nature of the asset class means that you have to be global in nature, global in focus. So this is an asset class which has significant representation across all geographic regions. Europe, Latin America and Asia, as well as portions in Africa, so global perspective is important. Secondly is exposure to interest rates and currency. So investors who are looking for exposure to those asset classes, emerging market local makes sense. And, lastly, in terms of both volatility and in terms of time horizon, now this is an asset class which historically has been a higher volatility consideration for investors. That’s largely because of the currency volatility we’ve seen historically. So, as a result, within the fixed income spectrum, emerging market local current tends to be a higher volatility opportunity set. As a result, it suits investors who have a longer-term time horizon to reap the rewards of investing in this asset class over the medium term, the higher yields and the opportunity set it provides.

Emerging market sovereign debt, i.e. dollar-denominated government debt versus emerging market local currency debt, are quite different asset classes. In fact they’re very similar in terms of their prefix of emerging markets, but not necessarily in terms of their risk and return profiles. So they’re quite different. First and foremost emerging market local currency debt is driven by economic cycles and interest rate cycles across the developing world. And then by the currency movements we see within those economies versus the US dollar, or versus other currencies if you have any funding currencies; for instance sterling-based investors or European-based investors. So the two main drivers really are the economic cycle, and what that means for interest rates and yields, and the currency movements.

Now, in terms of emerging market dollar sovereign debt, the drivers of risk and return there are quite different. On the interest rate side, it’s driven largely by what happens in the US treasury market, and what happen to credit spreads, i.e. the relative credit quality of the countries involved. So the risk and return drivers of the two asset classes are quite different. In addition to which liquidity is quite different. The emerging market local currency debt universe tends to be more liquid, particularly at times of stress, than the emerging market dollar markets, and lastly in terms of breadth. Now, the asset class I look at, emerging market local, is very broad globally. It looks across Europe, Asia, Latin America and Africa; however, the emerging market dollar sovereign asset class is broader. It has more representation, more global names within it, more opportunity, a wider opportunity set.

I often think about emerging market local currency as a combination of two assets. So let’s think about them in turn. On the debt side the emerging market local currency asset class is a largely investment grade relatively short duration, around about five years, five to six years, relatively high yielding asset class, which is globally diverse. So I think that’s an important consideration first. It’s about the coupon that you get paid and about the interest rate dynamics of the markets within the universe. In addition to which the second component of the asset class is the currency. Now this tends to be more volatile. It tends to drive the risks of the asset class, rather than the returns historically, and drives a lot of the alpha opportunities too. As a result the asset class in combination has historically been quite volatile, but it gives the active manager lots of opportunity to outperform. And over time on a long-term basis the volatility of the currency does tend to dampen down. But in the interim period, or the medium term, it’s important to consider the asset class in my opinion as two separate asset classes, the bond side and the currency side, and therefore how you actively manage the portfolios for clients is driven by that.

We believe the EM universe is clearly well aligned to active management. Now obviously we’ve seen over the last decade or so a significant rise in passive investment globally and across asset classes. And we’ve seen that in emerging markets as well. However when you think about what drives the asset class’ risk and return, opportunities for active outperformance is significant. So we think active management in EM makes a lot of sense. There’s lots of opportunities around alpha, there’s lots of pricing inefficiencies, there’s lots of opportunities for generated a better outcome for clients than through a passive investment. More broadly if you think about passive versus active, there are a few major focal points you need to think about from an investment point of view.

First and foremost yield on the asset class you’re investing in in emerging markets, these are notably higher than developed markets, so a client receives a higher yield and a higher net yield post fees. This is obviously an area where developed markets with very low yields become quite a difficult value proposition for clients, when you think about how much yield you’re getting versus the fees you’re paying, which has made passive more attractive for those asset classes. In addition to which the opportunity set within emerging markets is very large. I mentioned this earlier in terms of pricing inefficiencies. But the opportunity for managers to generate alpha for the client are bigger. And lastly passive tends to underperform the benchmark because of the costs involved in managing assets versus the emerging market indices. So when you think about yields, net yields, i.e. yields after fees, opportunity for active outperformance and the historical relatively poorer performance of passive because of the costs involved, we think active makes a lot of sense in emerging markets.

The key considerations one has to make for emerging market local in terms of getting good outcomes for clients we think are threefold. First and foremost investing by nature is uncertain. So one has to have a consistent and applicable process over time to generate alpha; that’s what we’re here to do. You do that by in our opinion simplistically looking at where the good stories are fundamentally, where the cheaper valuations are and where the opportunity arises from a lack of sponsorship from other investors. So simplistically how good are the fundamentals, how good is the story? What’s the valuations like, how cheap is the story? And technicals, what is the positioning like, how owned or under owned is the story? By applying these three main drivers in a consistent way you can identify opportunities for generating alpha over time. In addition to which think a little bit about the drivers of risk and return within the asset class. Historically bonds and the coupon attached to those have driven returns; currency has historically driven the volatility. So, in terms of active management, if one can apply consistent process, and try and minimise some of the risks on the currency side whilst generating returns through the interest rate cycle on the bond side, that should generate a better outcome for the client.

In our opinion investing in emerging markets from an active perspective makes a lot of sense, certainly versus passive opportunities. Why is that? One volatility in the asset class is very large and dispersion of returns is very wide; that means that active opportunities are large. So the ability to generate alpha, or reduce risks, or preferably do both, are much more substantive in emerging markets than many of the developed markets. Secondly when it comes to passive there are costs involved in investing in emerging markets, taxes, transaction costs and the like, which mean that often passive opportunities have underperformed their benchmarks. Active management allows the opportunity to outperform the benchmark, and we think that’s important. And lastly we’ve seen a rise in passive investment in some of the lower yielding or more core products within developed markets. Yields are low, therefore clients are incentivised to reduce costs in investing in those markets. Of course in emerging markets where yields are much higher, the absolute yield and the net yield the client receives is much higher, therefore active opportunities look more attractive.

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