Emerging markets debt is typically seen as an asset class in which investors can gain alpha through using active and usually external managers that charge for their niche access to segments of the market and on-the-ground local expertise.
However, two large institutional investors – Danish pension fund PFA and New Zealand Superannuation Fund – are taking a different approach.
PFA’s internal investment team has managed their emerging markets debt for more than a decade. Their holdings encompass the spectrum of available securities from US-denominated and local currency sovereigns to corporate debt.
New Zealand Super, the country’s sovereign wealth fund, approaches fixed income with the overriding aim of capturing the broadest exposure possible.
To achieve this goal the fund’s investment team have customised its own index, which attempts to capture the broad fixed-income universe, including emerging markets debt.
Both approaches are at odds with the approach advocated by top global consultants Top1000funds.com spoke to (click here to view story), who unanimously favoured investors seeking external, active managers for emerging markets debt.
PFA and tactical autonomy
PFA senior portfolio manager, Ulrik Roux Wolke, heads up the emerging-markets-debt team at the fund. He says that PFA generally favours internal management, and, despite the distance of the Danish fund from the markets it is investing in, emerging markets are no different.
“We believe in retaining knowledge internally; it adds quite a lot of value, also in terms of asset-allocation purposes and also for getting an overview of the market,” Wolke says.
“Every time you outsource, you lose a lot of knowledge. You can, to some extent, also argue that you cannot choose a manager if you don’t have a deep knowledge of the asset class.”
Emerging markets debt makes up 25 per cent of the fund’s strategic allocation to its credit bucket. The remaining credit allocation is split between 50 per cent investment-grade, developed-market corporate credit and 25 per cent US high-yield.
Of this 25 per cent strategic allocation to emerging markets debt, 85 per cent goes to hard-currency sovereign, with the remaining 15 per cent assigned to local-currency sovereign.
Wolke and his team are given autonomy to make tactical allocations to emerging market corporate debt.
Having the freedom to act tactically without pre-determined limits, which for external managers are often around such things as credit quality, is one of the advantages of internally management, according to Wolke.
“We prefer not to limit ourselves to very mechanical rules such as investment grade only. Rules such as credit quality are not a good substitute for risk management with in depth knowledge of the credit risk,” he says.
“I understand if you have an external manager but it is one of the positive sides of internal management that you can have a dialogue instead of having to impose rigid and not very workable rules.”
Wolke rejects the notion that external managers benefit from being close to the markets they are investing in, saying that being in Copenhagen and investing in emerging markets is no different to bond traders in London managing global portfolios.
“I also travel a lot and I am regularly visiting the markets in which we invest,” he says.
The internal team has the capacity to invest in ways that are essentially the same as an external manager, according to Wolke.
On and off benchmarks
PFA benchmarks its internal emerging-market performance on the JP Morgan EMBI Global Diversified index.
The internal team then takes a number of off-benchmark positions. While he was not prepared to disclose the current positioning of the fund’s emerging markets debt portfolio, Wolke did say the fund takes off-benchmark positions, including in euro-denominated bonds, emerging-markets corporate and local debt.
Wolke says the off-benchmark positions are generally aimed at gaining an average credit quality that is higher than the index.
JP Morgan’s EMBI Global Diversified index has an average credit quality of Baa3/BBB-.
“I don’t believe in a strong rally of anything at the moment, so I think it is better to provision a bit and have some buffers,” he says.
The team also uses derivatives for a small proportion of its emerging-markets-debt portfolio.
“The advantage of derivatives is that you get a cleaner exposure. If you want exposure to a give credit risk, you can do it a lot cleaner without liquidity premium or a special duration segment which could be influenced by a couple of big investors,” he says.
The strategic allocation is also unhedged with the internal team free to make tactical hedges on a currency-by-currency basis, Wolke says.
The current position of the emerging markets debt is underweight local debt and corporate debt due the internal team seeing more attractive opportunities in US high yield.
Wolke identifies strong fundamentals in US high: “For the moment there is fairly positive redemption and maturity profile for the debt.”
The strong balance sheets of US corporations and good spread also adds to the case for US high yield, according to Wolke, who says the shorter duration of US high yield also makes it easier to manage potential interest-rate risk.
However, while there is a fair amount of tactical autonomy, Wolke says there is a view that the strategic allocation provides a base level of diversification.
“The 50/25/25 split is probably the minimum it can get down to in order to retain the diversification effect… The new norm is a lot of things are correlated, but I still think there is a need for diversification, otherwise you expose yourself to a lot of credit risk,” he says.
Diversification is a key advantage of New Zealand Superannuation Fund’s approach to the positioning of its fixed-income portfolio.
The fund’s head of asset allocation, David Iverson, says that the fund has chosen to index its fixed income. The internal investment team uses its own bespoke blend of global, high-yield and emerging-market indexes to capture the broadest exposure possible to the total fixed-income universe.
“There is no single index that gives us a suitably broad exposure, so we have customised our own benchmark to capture the fixed-income universe as best we can using existing well defined and well accepted benchmarks.”
The primary index is the Barclays Capital Global Aggregate Bond Index, with the investment team also using an emerging-market hard-currency-debt index and a global high-yield index from the same Barclays family of indices. In addition, the fund also adds into its customised benchmark a global inflation-linked bond index.
“When we put these together, the global high-yield index and the global aggregate index have underlying criteria that creates a small overlap, but they virtually more than 90 per cent of the emerging-markets-debt index,” Iverson says.
“This means that we have emerging markets debt securities already in our customised index, so we have already captured that segment of the market.”
Iverson explains that the internal investment team generally sees little value-add from traditional external managers in the fixed-income space.
“Have we gained a broad exposure to the fixed-income universe is the first question,” he says.
“The second question – to go active or passive – depends on whether we think the manager can outperform the benchmark. Based on our current assessment, there isn’t enough additional return that managers can add in order to make it worthwhile to go active.”
The current exposure to emerging markets debt is limited to hard-currency exposures.
This exposure represents 1.8 per cent of the fund’s total fixed-income exposure. Because the fund has a more-than-80-per-cent allocation to equities, at the total fund level this represents a 0.4 per cent exposure to emerging markets debt in its benchmark portfolio and 0.2 per cent in its actual portfolio.
Two years ago the fund decided to diverge from allocating assets according to a long-term strategic asset allocation and now actively allocates assets away from a reference portfolio.
Iverson, who was formerly head of Russell Investment Consulting in New Zealand, says that the reference portfolio is comprised of low-cost, simple investments capable of achieving the fund’s objectives. It then becomes a basis against which active decisions are made and assessed
The reference portfolio acts as a measure of the performance of the investment team. In addition, it is also a real measure of the internal team’s decision-making and also acts as a governance benchmark. A small internal team is only needed to operate the reference portfolio.
The approach the investment team takes to indexing its fixed income portfolio takes a lot of the complexity out of the decision-making process around how to maintain a relevant exposure to fixed income relative to increasing proportion of the total fixed income universe.
While the actual allocation to emerging markets is relatively small at this stage, the customised index has the capacity to increase exposure to emerging markets as they become a bigger slice of the fixed-income universe, Iverson explains.
“In the first instance, what we do is we try to capture the market in proportion to its market capitalisation and whatever size of the emerging-markets-debt universe. So, say if there is more issuance, then the market value increases and the weight automatically goes up,” he says. “We don’t have to think about how large the emerging-market universe is becoming and to reweight to it.”
The global trend in emerging markets debt (that sees the market for hard-currency sovereign debt shrinking as more emerging-market countries start issuing debt in their local currency) has provided food for thought for the investment team.
Maintaining breadth of the fixed-income portfolio means that the fund is investigating gaining exposure to local debt, Iverson says.
“There is a reasonable amount of emerging markets debt in local currency that is and has been issued, making it a significant part of the universe,” he says.
“That is something we have looked to investigate and, if there are sufficiently well defined indices, we will customise our index to include them as well.”