Consultants advocate active EMD management

Consultants are recommending investors have as much as 10 per cent of their fixed-income portfolio in emerging markets debt with endowments, public pension funds and even some corporate clients using liability driven investment strategies showing increasing interest in the asset class.

Top1000funds.com spoke to consultants from Callan Associates, Hewitt EnnisKnupp, Cambridge Associates and Russell Investments who universally advocated investors actively manage emerging-markets-debt allocations.

Karen Harris, vice president for Callan Associates’ capital markets research group, says they are seeing increasing interest in the asset class from public pension funds, which have to achieve return targets of around the 8 per cent mark, as well as insurance companies.

The higher yields on offer in emerging markets debt are attractive to these investors, according to Harris. Callan’s analysis shows that the asset class generally has a low correlation to US fixed income and a higher correlation to US equity.

Harris notes that most new investors to the asset class have looked to go into US dollar-denominated sovereign debt as an introduction to the asset class, with the JP Morgan EMBI Global Diversified index the most popular benchmark.

Callan is also seeing increasing interest in local-currency offerings. However, emerging markets corporate debt is generally viewed as more of a tactical allocation, typically accessed through active management.

Harris says investors can also gain from active managers who can provide broader exposure given the index universe doesn’t currently represent the available opportunity set.

“Callan recommends up to 10 per cent of the fixed-income portfolio could go into emerging markets. If you took the market-cap weight of all the emerging market opportunities in the benchmarks, it is probably 3 to 7 per cent of all global fixed income” Harris says.

“Then, if you said ‘what about all the other bonds not included in these indexes?’, managers are putting out numbers that say the universe of EMD is up to 25 per cent of the global-bond-market cap, then we think somewhere between index-market cap and potential global opportunity sounds like a reasonable strategic allocation.”

A good fit for insurance funds

This 10 per cent allocation was also seen as an advisable level of exposure by consultants from Russell and Hewitt EnnisKnupp.

While Harris says Callan is seeing limited interest from corporate pension funds in emerging markets debt, insurance companies with large fixed-income allocations see attractive diversification opportunities in emerging markets debt.

In addition to the potentially higher yields on offer relative to most developed market debt, emerging markets debt is also a good fit for the overall investment objectives and regulatory requirements of insurance funds.

“Due to the statutory requirements, insurance companies do not carry bonds at market value; they carry them at book or amortised cost so book yields to some degree are as important to insurance companies,” Harris explains.

She is typically seeing allocations to emerging markets debt of between 5 and 10 per cent of a fixed-income portfolio from large institutional investors.

Emerging markets debt does not have a role to play in a fixed-income portfolio for Cambridge Associates, says the consultant’s Singapore-based managing director Aaron Costello.

Cambridge believes that the role of fixed income should be extremely defensive, providing a source of liquidity in times of market stress.

Accordingly, Cambridge advises that fixed-income holdings should generally be high quality bonds in the investor’s home country.

“The idea of combining EM debt into your fixed-income portfolio, if you view it as a source of safety, is suboptimal to us,” Costello says.

The role of emerging markets debt for Cambridge, therefore, is as a diversifying asset.

“While emerging markets debt will tend to be risk-on, they are certainly less volatile and less correlated to global equities than, say, emerging market equity for example,” he says.

“So in the current environment, it is a way of increasing returns over a fixed-income portfolio without taking full equity risk.”

 Emerging-markets-debt exposure on the rise

This diversifying characteristic for emerging markets debt makes the asset class interesting today from a risk-adjusted return perspective, along with high-yield developed-market bonds and certain hedge fund strategies, according to Costello.

T. Rowe Price portfolio manager for emerging markets debt strategy, Mike Conelius, says that, despite flows into emerging markets debt having grown strongly over the past decade, it is just the start of a global shift to emerging market assets.

While acknowledging that some investors will have exposure to emerging markets debt through globally focused bond indexes, he says that this still represents a considerable underweight relative to the opportunity set.

“The flows coming from the developed world are really now just kicking in and clearly they are leaving the developed world,” Conelius says.

“The numbers we have seen are around 3 per cent of fixed-income allocations and it has to be the biggest underweight in a global context, especially when adjusted for fundamentals.”

Costello notes that in 1999 only 15 per cent of their surveyed endowment-client base had an exposure to emerging markets debt, with the average size just 1 per cent of the total portfolio.

This allocation remained fairly static through most of the subsequent decade until the last couple of years.

Cambridge figures show by the first quarter of this year almost 40 per cent of its clients reporting an exposure to emerging markets debt.

The average allocation was 2 per cent of an overall portfolio, with allocations above 4 per cent generally considered large.

Attractive duration diversity

In contrast with Callan, Hewitt Ennis Knupp’s Chicago-based senior consultant Francois Otieno says they are seeing burgeoning interest among US corporate clients looking to include small allocations of emerging markets debt into their portfolios.

While noting that this is currently at the “discussion phase”, Otieno says that emerging markets debt can offer attractive duration diversity for some liability-driven investments (LDI).

“I won’t say these discussions are at are at the general level, but we are starting to talk with some clients about emerging markets debt as part of a broader LDI-type allocation,” he says.

“As you are building out an LDI framework, clearly it is long duration-focused, but as you are building that glide path you do allocate to a number of different materials across the yield curve. So, emerging markets debt is not generally issued at the long end and it generally plays a role in the intermediary part of the curve. It is really a yield play.”

Otieno is seeing allocations among some public pension funds of as much as 30 per cent of their fixed-income portfolio in emerging markets debt.

Russell Investments UK-based portfolio manager, James Mitchell, says that emerging markets debt generally forms part of the growth component of investors’ fixed-income portfolio.

“Investors are typically looking to build out an emerging-market sovereign-debt component with a 50/50 split between hard and local currency,” Mitchell says.